Unit Two.

Identifying bad and doubtful debts

Introduction
 Bad debt is a specifically-identified account receivable that will not be paid and so
should be written off at once.
 While a doubtful debt is one that may become a bad debt in the future and for which it
may be necessary to create an allowance for doubtful.
 Bad debts are uncollectible amounts from customer accounts. Bad debt negatively affects
accounts receivable. When future collection of receivables cannot be reasonably assumed,
recognizing this potential nonpayment is required.
 There are two methods a company may use to recognize bad debt: the direct write-off
method and the allowance method.
1. The direct write-off method delays recognition of bad debt until the specific customer
accounts receivable is identified. Once this account is identified as uncollectible, the
company will record a reduction to the customer’s accounts receivable and an increase
to bad debt expense for the exact amount uncollectible.
 Under generally accepted accounting principles (GAAP), the direct write-off method is
not an acceptable method of recording bad debts, because it violates the matching
principle.
Recording/Recognizing Bad Debt
 For example, a customer takes out a $15,000 car loan on August 1, 2018 and is expected to
pay the amount in full before December 1, 2018. For the sake of this example, assume that
there was no interest charged to the buyer because of the short-term nature or life of the loan.
When the account defaults for nonpayment on December 1, the company would record the
following journal entry to recognize bad debt.

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 Bad Debt Expense increases (debit), and Accounts Receivable decreases (credit) for $15,000.
If, in the future, any part of the debt is recovered, a reversal of the previously written-off bad
debt and the collection recognition is required.
 Let’s say the customer unexpectedly pays in full on May 1, 2019, the company would
record the following journal entries (note that the company’s fiscal year ends on June 30)

 The first entry reverses the bad debt write-off by increasing Accounts Receivable (debit) and
decreasing Bad Debt Expense (credit) for the amount recovered. The second entry records
the payment in full with Cash increasing (debit) and Accounts Receivable decreasing (credit)
for the amount received of $15,000.
2. Allowance Method
 The allowance method is the more widely used method because it satisfies the matching
principle.
 The allowance method estimates bad debt during a period, based on certain computational
approaches. The calculation matches bad debt with related sales during the period.
 The estimation is made from past experience and industry standards. When the estimation is
recorded at the end of a period, the following entry occurs.

 The journal entry for the Bad Debt Expense increases (debit) the expense’s balance, and the
Allowance for Doubtful Accounts increases (credit) the balance in the Allowance.
 The allowance for doubtful accounts is a contra asset account and is subtracted from
Accounts Receivable to determine the Net Realizable Value of the Accounts Receivable
account on the balance sheet.

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 A contra account has an opposite normal balance to its paired account, thereby reducing or
increasing the balance in the paired account at the end of a period; the adjustment can be an
addition or a subtraction from a controlling account. In the case of the allowance for doubtful
accounts, it is a contra account that is used to reduce the Controlling account, Accounts
Receivable.
 At the end of an accounting period, the Allowance for Doubtful Accounts reduces the
Accounts Receivable to produce Net Accounts Receivable. Note that allowance for doubtful
accounts reduces the overall accounts receivable account, not a specific accounts receivable
assigned to a customer. Because it is estimation, it means the exact account that is (or will
become) uncollectible is not yet known.
 To demonstrate the treatment of the allowance for doubtful accounts on the balance sheet,
assume that a company has reported an Accounts Receivable balance of $90,000 and a
Balance in the Allowance of Doubtful Accounts of $4,800. The following table reflects how
the relationship would be reflected in the current (short-term) section of the company’s
Balance Sheet.

 There is one more point about the use of the contra account, Allowance for Doubtful
Accounts. In this example, the $85,200 total is the net realizable value, or the amount of
accounts anticipated to be collected. However, the company is owed $90,000 and will still try
to collect the entire $90,000 and not just the $85,200
Reviewing debtor’s ledgers
 The customers who owe money to the business are called debtors.
 The Debtor‟s Ledger is one of the subsidiary ledgers to the general ledger. It accumulates
information as a result of monthly postings from the Sales Journal.
 The debtors' subsidiary ledger is a sub-system in the overall accounting system. It
maintains an account for each debtor and records detailed information (not totals) about
debtors from the sales journal and cash receipts journal.

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Calculate the Bad Debt
There are three main ways that we can calculate bad debt.
1. Percentage of Sales Method - A percentage of what we sell for that year.
 For example, for an accounting period, a business reported net credit sales of $50,000.
Using the percentage of sales method, they estimated that 5% of their credit sales would be
uncollectible. In this case, the business estimates that it would incur an amount of $2,500
($50,000 x 5%) as bad debt expense
2. Percentage of Receivables Method - A percentage of whatever our receivables balances,
 Percentage of Bad Debt = Total Bad Debts / Total Credit Sales. Once this percentage is
established, it's applied to current period credit sales to calculate the expected bad debt
expense:
Bad Debt Expense = Estimated % × Total Credit Sales. ...
Bad Debt Expense = 0.015 × $200,000 = $3,000.
3. Aging Schedule or Aging of Receivables - We itemize those things based upon age of the
specific payable.
 The aging of receivables method is a powerful tool for estimating bad debt. It lets you assess the
likelihood of collecting outstanding invoices based on how long they’ve been outstanding. The
older an invoice gets, the less likely it is to be paid. This principle underpins the aging method,
which categorizes outstanding invoices into age groups, helping you predict potential losses from
uncollectible accounts.
 Example, Imagine a company with $89,400 in accounts receivable. After reviewing their aging
report, they categorize their invoices like this:
 0-30 days: $50,000
 31-60 days: $20,000
 61-90 days: $10,000
 90+ days: $9,400
 Next, the company assigns estimated uncollectibility percentages to each category based on their
historical data. This is where understanding your own business’s payment patterns become
really valuable. Industry benchmarks can also provide a helpful starting point.
 0-30 days: 1%
 31-60 days: 5%

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  61-90 days: 15%
 90+ days: 50%
 Now, the company calculates the estimated bad debt for each category:
 0-30 days: $50,000 × 1% = $500
 31-60 days: $20,000 × 5% = $1,000
 61-90 days: $10,000 × 15% = $1,500
 90+ days: $9,400 × 50% = $4,700
 Adding these amounts gives a total estimated bad debt expense of $7,700. This represents the
portion of receivables the company anticipates won’t be collected, allowing them to adjust their
financial statements accordingly