What are Bad Debts?
Bad Debts are the unrealized amounts from the customers that they never going to pay back to the business. The main source of the revenue in any business is the sale of goods or services to customers on credit. Such sales either involve payment in lump sum or in installments over the period of time.
This results in rise in the sales revenue as well as accounts receivable of the business. And when customers does not pay their obligations, this result in increasing the loss in these accounts.
Bad Debts Example
Suppose ABC company began the operations in 2010 and made sales of about 10,00,000, all on credit. Let’s assume, company does not receive any money from the customers. This results in accounts receivables of Rs. 10,00,000.
Accounts Receivable will appear on the assets side of balance sheet under current assets head. On the other hand, in income statement, it appears as sales revenue. But this will happen only when all the customers will pay off their bills. In reality, there are some customers who did not pay their bills. Hence, their accounts become bad accounts.
Suppose a person makes a purchase with no intention of paying for it, so he does not pay it. In such case, an organisation has not made any sale. No revenue is earned and nothing was added to the accounts receivable account of the company. If you record this transaction, it will result in overstated of sales revenue and accounts receivables.
There are some occasions when the customers really want to make payment but due to some reasons he was not able to do so. The treatment of bad debts is same as in Case 1.
Accounting Treatment of Bad Debts
There are two methods to record the bad debts in the books of account. One way of making this adjustment is by the direct write – off method. Accounts that are believed to be uncollectible are simply erased from the records by subtracting bad debts amount from accounts receivable. Then the same amount appears as an expense in the income statement. The journal of this adjustment is as follows –
Bad Debts Expense A/c Dr.
To Accounts Receivable
Second way is the allowance method. In this method, accountant estimates the certain amount for uncollectibles. This amount appears as an expense in the income statement. On the other hand, in balance sheet, amount gets subtracted from accounts receivables. The adjusting entry is as follows –
Bad Debts A/c Dr.
To Allowance for Bad Debts