BAD DEBTS: CHARACTERISTICS, ESTIMATION AND EXAMPLES - DUDAS - 2024

The uncollectible accounts are accounts receivable corresponding to credit sales, loans or other debts that have virtually no chance of being paid by the debtor to the company. Unfortunately, not all customers who make purchases on credit will pay companies the money owed to them.

An account can become uncollectible for many reasons, such as the bankruptcy of the debtor, the inability to find the debtor, fraud on the part of the debtor, or lack of proper documentation to prove that a debt exists.

Source: pixabay.com

When an account receivable is determined to be uncollectible, no future economic benefit can be expected from it. It no longer qualifies to be an asset and therefore must be derecognized.

Bad debts are a loss of assets and a decrease in income, which is recorded as an expense, known as a bad debt expense.

Sell ​​on credit

A certain amount of bad debts is considered part of a normal business operation.

This should not discourage companies from selling their products on credit, because if companies stop selling them on credit due to fear of having bad accounts, good customers will also be turned away and many sales opportunities will be lost.

Therefore, companies adopt sound credit policies to maximize the benefit of credit sales.

characteristics

Bad debt expense is the amount of accounts receivable that is considered to be uncollectible. The amount of bad debts that is expensed is the result of one of two methods:

Direct cancellation method

When it is verified that the invoice of a specific client will not be paid, the amount of the invoice is charged directly to the expense of bad debts.

Therefore, a specific receivable is removed from the accounting records when it is ultimately determined to be uncollectible. The input for the direct cancellation method is as follows:

This entry reduces the accounts receivable balance of the item that cannot be collected. The debit goes to an expense account: Bad Debt Expense.

An important accounting principle is the notion of congruence. That is, costs related to income generation must be reported during the same accounting period as income.

Since the company may attempt to collect the money owed over several months, the direct write-off method violates the principle of consistency, and therefore should not be used to value accounts receivable in the financial statements.

Provision method

When sales transactions are recorded, an amount related to bad debts expense is also recorded, since in theory the approximate amount of bad debts can be determined based on historical results.

This is recorded as a debit to the doubtful accounts expense account and a credit to the doubtful accounts provision account.

The actual elimination of the unpaid accounts receivable is carried out later, reducing the amount in the provision account. This is not a reduction in sales.

The calculation of bad debt expense under the provisioning method can be estimated in several ways.

Allowance for doubtful accounts

Percentage of credit sales method

This method automatically estimates a percentage of credit sales as an expense, based on historical data.

Suppose a company prepares financial statements weekly. Your past experience indicates that 0.3% of your credit sales will never be collected.

Using the percentage of credit sales method, the company automatically charges 0.3% of each week's credit sales to bad debt expense and credits it against the allowance for doubtful accounts.

Suppose that in the current week this company sells $ 500,000 on credit. The bad debt expense of $ 1,500 (0.003 x $ 500,000) is calculated and the following journal entry is recorded:

The percentage of credit sales method focuses on the income statement and the principle of consistency. The $ 500,000 sales revenue is immediately combined with the $ 1,500 of bad debt expense.

If you're a new business, you may be able to calculate your bad debt expenses using an industry average, until you can develop your own experience rate.

Expiration method

Classify accounts receivable into different maturity groups. According to this method, the longer the period for which an account receivable remains outstanding, the lower the chances of its collection.

The estimate of the provision for doubtful accounts is made through a percentage of accounts receivable that is considered uncollectible in each maturity group.

This percentage is usually different for each maturity group and is estimated based on past experience and current economic conditions in the areas where the company operates.

The estimated uncollectible percentage for each maturity group is applied to the total amount of accounts receivable in that group to obtain an estimated uncollectible amount from the group.

The estimated bad debts for all maturity groups are calculated separately and added together to find the total estimated bad debts.

This total estimated uncollectible amount represents the required balance in the provision for doubtful accounts at the end of the period.

Bad debts on the balance sheet

Accounts receivable are known as control accounts. This means that the total of all the individual accounts in the subledger must equal the total balance in the accounts receivable.

Bad debts are used in the valuation of accounts receivable, which appear on a company's balance sheet.

When a customer purchases on credit from the supplier, that amount is placed by the supplier in accounts receivable. Payment terms vary, but most companies pay within 30 to 90 days.

If a customer has not paid after three months, the amount is allocated to "past due" accounts receivable. If more time passes, the provider could classify it as a "doubtful" account.

At this point, the company may elect to charge the income statement, in the form of a bad debt expense.

The bad debt expense account appears as an element of the income statement, within the operating expenses section of that financial statement.

Cancellation of a bad account

The entry to write off a bad debt only affects the balance sheet accounts: a debit in the provision for doubtful accounts and a credit in the accounts receivable.

No expenses or losses are recorded in the income statement. This is because this write-off is "covered" in the previous adjustment entries for the estimated bad debt expense.

Provision

To compensate for the problem of the direct write-off method, accountants have developed different allocation methods to provision bad debts.

The provision method uses an estimate of bad debts, also known as bad debt expense. This method does not predict which individual accounts will be canceled.

For this reason, the adjustment to accounts receivable is made using a provision as a counter-account of assets for doubtful accounts. This counter-account is known as: "Provision for uncollectible accounts".

This allows companies to display accounts receivable on the balance sheet as: "Net realizable value."

A provisioning method should always be used, except in cases where bad debts are not material. It is also exempted for tax purposes, when tax regulations stipulate that a direct cancellation method must be used.

The provisioning methods will generate the recording of an estimated bad debt expense in the same period as the related credit sales. This results in a fairer valuation of the balance sheet for outstanding accounts receivable.

Examples

Provision for credit sales

The ending balance of accounts receivable for the first quarter of Company A was $ 3,867,000. Using the percentage of sales method, Company A determined that the bad debt expense in the current quarter would be $ 16,350 (2% of credit sales).

The current balance in the provision for doubtful accounts is $ 60,990. The journal entry for bad debt expense would be:

The balance in the provision for doubtful accounts would now be: $ 60,990 + $ 16,350 = $ 77,340.

The net realizable value of accounts receivable, as shown on Company A's balance sheet, would be:

Expiration method

The Fast Company segmented its accounts receivable into five maturity groups by preparing the following maturity schedule:

Based on past experience and current economic conditions, the company has determined the percentage of credit losses credited in each maturity group as follows:

- Not expired: 1%

- 1-30 days past due: 3%

- 31-60 days past due: 10%

- 61-90 days past due: 20%

- More than 90 days past due: 50%

At the end of 2017, the provision for doubtful accounts shows a balance on the balance sheet of $ 2,000.

The estimated total amount of bad debts is calculated. This is the required balance in the provision for doubtful accounts, based on the reference information.

Based on the above calculations, the total estimated uncollectible amount at the end of the year is $ 2,840. This represents the required balance in the provision for doubtful accounts at the end of the period.

Since the company already has a credit balance of $ 2,000 in the provision for doubtful accounts, the year-end adjustment entry will be made in the amount of only $ 840 ($ 2,840 - $ 2,000):

With this entry, the balance in the provision for doubtful accounts will increase from $ 2,000 to $ 2,840.

References

1. Investopedia (2018). Accounts Uncollectible. Taken from: investopedia.com.
2. Money-zine (2018). Uncollectible Accounts Receivable. Taken from: money-zine.com.
3. Harold Averkamp (2018). Accounts Receivable and Bad Debts Expense. Accounting Coach. Taken from: accountingcoach.com.
4. Principles of Accounting (2018). Accounting For Uncollectible Receivables. Taken from: principlesofaccounting.com.
5. Accounting for Management (2018). Estimating allowance for doubtful accounts by aging method. Taken from: accountingformanagement.org.
6. Steven Bragg (2017). Bad debt expense. Accounting Tools. Taken from: accountingtools.com.
7. John Cromwell (2018). What Is an Uncollectible in Accounts Receivable? Small Business - Chron. Taken from: smallbusiness.chron.com.