How to account for bad debt?
This is a short but complete guide of the terminology of bad debt accounting, illustrated
with examples and journal entries.
This video covers concepts such as direct write-off, various methods to calculate the
bad debt allowance, how bad debt write-off and the bad debt allowance method relate,
and as a bonus how bad debt accounting works in the case of fraud in accounting statements.
Let’s get started with a simple example, and build up the discussion of bad debt with
step-by-step examples.
Let’s imagine a perfect world where every customer always pays his bills.
In that case, you need just three accounts to record the journal entries for the billing
and collection cycle: revenue in the income statement, accounts receivable on the balance
sheet, and cash on the balance sheet.
If ABC Company bills $100 in revenue to customers in year 1, and customers pay $90 of this $100
during that same year 1, then the ending outstanding accounts receivable balance at the end of
the year is $10.
In the management reporting of company ABC, the Days Sales Outstanding metric (how long
it takes on average for a customer to pay) would be this outstanding accounts receivable
balance of $10 divided by full year revenue of $100, times 360 days, is 36 days DSO.
Maybe the terms in contracts with customers are 30 days, and customers are on average
6 days late in paying, but every customer pays in the end.
Second year.
Revenue of $200, collections of $190.
The ending accounts receivable balance equals the opening balance of $10 (carried over from
last year), plus revenue of $200, minus collections of $190, is $20.
Days Sales Outstanding is stable at 10% of revenue, or 36 days.
Third year.
Revenue of $300, collections of only $280.
The ending accounts receivable balance equals the opening balance of $20 (carried over from
last year), plus revenue of $300, minus collections of $280, is $40.
Days Sales Outstanding deteriorates to 48 days.
This is where management starts wondering what is going on, as this DSO increase is
very large versus previous years.
The terms in the contracts with the customers have not changed, so there must be an issue
with late payment.
They start investigating, and find out that one of their customers, XYZ Corporation, has
gone bankrupt, and none of the $10 receivable that ABC had on XYZ is recoverable.
This is where ABC Company would book a direct write-off.
As there is no hope of collection, the accounts receivable asset is removed from the balance
sheet by crediting the Accounts Receivable account.
The debit of the journal entry goes to Bad debt expense in the income statement.
A very painful step to take for the management of ABC Company, which is partially due to
their reactive view on receivables collection, and the naïve assumption that every customer
always pays.
They decide that going forward, ABC Company will be more prudent and book an allowance
for doubtful accounts on a periodic basis, based on expected credit losses.
The debit of the journal entry goes to Bad debt expense, the credit to a balance sheet
contra account called Allowance for doubtful debt.
There are several ways to calculate and record this allowance.
The first method is called the income statement method, as it looks at income statement data
to record the allowance for doubtful debt.
Based on the revenue of $400 in year 4, and historical write-offs of around 2% of sales,
management decides to put aside $8 in the Allowance for doubtful debt account.
The impact of recording the allowance on the income statement is: in revenue the full amount
billed is recorded, the estimated credit loss gets recorded in Bad debt expense, which is
an account in the category of selling, general and administrative expenses or SG&A.
On the balance sheet, once we have recorded cash collections for the year, we can calculate
Accounts Receivable, net of allowance for doubtful accounts.
$30 opening balance for the year + $400 sales for the year - $390 collections - $8 doubtful
debt allowance = $32 net accounts receivable balance.
The second method to calculate the Allowance for doubtful debt is the balance sheet method,
as it looks at balance sheet data to record the allowance for doubtful debt.
$30 opening balance for the year + $400 sales for the year - $390 collections = $40 gross
accounts receivable balance at year end.
Management reviews this $40 outstanding balance in detail,
and estimates that 20% is considered uncollectible.
Debit Bad debt expense by $8, credit the balance sheet account
Allowance for doubtful debt by $8.
What are the ways to estimate this?
You could book the allowance (and related Bad debt expense) based on a specific review
of known troubled accounts, in other words you put specific names of specific customers
and specific open balances on your list for the bad debt accrual.
You could also take a more general approach, and assign a % probability of the open accounts
receivable balances not getting collected.
For example, X% allowance for accounts between 0 and 30 days overdue, a higher percentage
of Y% for accounts between 30 and 60 days overdue, and a yet higher percentage of Z%
for accounts more than 60 days overdue.
Or a hybrid method that combines the specific and generic approaches.
Whichever method you choose, support it with data from historical experience of write-offs
and any other industry- or country-specific data.
Now that an Allowance for doubtful accounts is in place, an actual write-off will not
be as painful, at least not from the income statement perspective.
Let’s assume another customer goes bankrupt, and there is zero hope of recovering any of
the outstanding balance.
It is therefore time to remove the asset from the balance sheet by crediting the Accounts
Receivable account for the $5 that this bankrupt customer will never pay, but this time the
debit goes to the Allowance for doubtful debt balance sheet account, not the Bad debt expense
in the income statement!
Before the write-off, the net accounts receivable balance after allowance was $32, and after
the write-off the net accounts receivable balance after allowance is still $32.
If a larger customer goes bankrupt, and the Allowance for doubtful debt is not sufficiently
high to cover the full amount, then $8 of the $10 gets debited to the Allowance, and
the remaining $2 has to go to Bad debt expense in the P&L.
The opposite could also occur.
If the Allowance for doubtful debt is not at all or only partially needed to cover actual
write-offs, then management could decide to release part of the Allowance for doubtful
debt back into the P&L, as a credit to Bad debt expense.
Obviously, the justification and calculation for taking such a step should be well thought
through and documented.
Bonus tip.
What if the accountant of ABC Company finds out that the increase in DSO in year 3 that
we discussed earlier was not caused by a real customer not paying, but by the company overstating
its revenue?
If ABC Company has booked fake invoices to artificially boost revenue, then that revenue
will obviously not be collected as there is no real customer to pay the invoices.
In that case, a receivable write-off would not be appropriate, but the company may get
forced to reverse part of its revenue booking, which lowers the revenue in the income statement
as well as lowers the outstanding Accounts Receivable balance.
That should provide a good start to understand the terminology of bad debt accounting, as
well as examples and journal entries.
I hope you enjoyed this short explanation of bad debt accounting.
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