Most businesses extend credit to others, whether that means making sales on credit to other businesses, loaning money to their officers, or loaning money to their vendors and employees. The act of extending credit is backed by some good business reasons, but businesses that do so also take the risk of not being paid. Some debtors may not pay up or pay the full amount owed. Retailers have to live with some amount of shoplifting losses, despite their best efforts to prevent it. In like manner, businesses those extend credit to their customers and make loans have to live with some amount of bad debts expense, despite their best efforts to screen customers and to collect overdue debts. Bad debt is the general term for these uncollectible receivables.
A business has two options for how it records its bad debts expense:
- Specific write-off method: No entry is made for bad debts expense until specific receivables are actually written-off as uncollectible. A receivable is not written off until every conceivable collection effort has been made and the debt has been discharged through bankruptcy proceedings or until the customer (or other debtor) has vanished and can’t be traced. One disadvantage of this method is that the receivables asset could be overstated because specific accounts have not as yet been identified as uncollectible that will in fact prove to be uncollectible in the future.
- Allowance method: Based on its collection experience with its credit customers (and other debtors) a business records bad debts expense before individual, specific receivables are identified as being uncollectible. The business estimates its bad debts expense, before all the facts are in regarding which particular receivables will have to be written-off as uncollectible. This is a more conservative method than the specific write-off method because bad debts expense is recorded sooner. One disadvantage is that the future amount of bad debts (receivables that will eventually be written-off) has to be estimated. Another disadvantage is that the income tax law does not permit this method to be used by most businesses.
Let’s assume that a business’s accounts receivable balance is $645,000 at year-end. The business hasn’t loaned money to employees, officers, or vendors. [Non-customer loans are recorded in other accounts, such as loans to officers]. The business didn’t write off any customers’ receivables during the year; however, at year-end, the amounts owed to the business by a few customers are several months overdue. The business shut off credit to these customers and sent them dun [please pay right now] letters. The customers have assured the business that they will pay but just need more time, so they say.
The business has done everything it can to get the customers to pay up, short of bringing legal action. As far as the business knows, none of these customers have declared bankruptcy, but the business has heard a rumor that one customer has contacted a lawyer about bankruptcy. The total amount overdue from these deadbeat customers is $18,500, and the business is of the opinion that the $18,500 will not be collected.
In addition, some other customers are two or three months overdue in paying their accounts. The business understands that some of these debts may end up being uncollectible, but it’s still hopeful that these overdue accounts will be collected in full.
Given the preceding background information, how much bad debts expense should the business record at the end of its first year according to:
- the specific write-off method for bad debts expense;
- the allowance method for bad debts expense?
Frankly, coming up with a bad debts expense amount for the year under either bad debts expense accounting method is somewhat arbitrary. Only time will tell exactly how much of the total $645,000 accounts receivable will not be collected.
Specific Write-off [Bad Debt] Method
The $18,500 seriously overdue amount of accounts receivable is written off by the specific write-off method for recording bad debts expense. The entry is as follows:
Note: The specific accounts receivable making up this $18,500 have been identified.
Considering that the company has identified specific customers and made reasonable efforts to collect the amounts owed to it, the receivables should be written off and charged to bad debts expense. This amount of expense is allowed for federal [USA] income tax purposes.
After making this write-off entry, the accounts receivable balance is $626,500 [$645,000 balance before write off – $18,500 write off = $626,500 adjusted balance of accounts receivable].
Some of this total amount of accounts receivable probably will turn out to be uncollectible. But the specific write-off method does not record these future write-offs at this time. The bad debts expense for the first year is $18,500 and the accounts receivable balance reported in its year-end balance sheet is $626,500.
Allowance [Bad Debt] Method
Using the allowance [bad debt] method for recording bad debts expense an additional amount of bad debts expense is recorded for the yet-to-be identified uncollectible receivables. Of course, the accountant has to estimate the amount of future write-offs. The argument is that some estimate is better than none. Suppose a conservative estimate of these additional bad debts is $20,000. However, specific customers’ accounts haven’t been identified for this estimated bad debts amount.
During the year, $18,500 has already been recorded in the bad debts expense account. As the specific receivables were identified as uncollectible during the year the business had no choice but to write-off the receivables and record bad debts expense.
Using the allowance method the accountant makes the following additional entry at the end of the year, which increases the bad debts expense account:
[Debit]. Bad Debts Expense = $20,000
[Credit]. Allowance for Doubtful Accounts = $20,000
The Allowance for Doubtful Accounts account is the contra account to the accounts receivable asset account. Its balance is deducted from the asset account’s balance in the balance sheet.
After giving effect to this year-end entry, the company’s bad debts expense for the year is $38,500 ($18,500 actually written-off during the year + $20,000 estimated uncollectible receivables to be written-off in the future]. In its year-end balance sheet the business reports accounts receivable at $626,500 and the $20,000 balance in the allowance for doubtful account is deducted from accounts receivable. So, the net amount of accounts receivables in its ending balance sheet is $606,500.
The IRS doesn’t allow most businesses to use the allowance bad debts expense method to determine annual taxable income. [This is a terrible pun]. Under the income tax rules, specific accounts receivable must actually be written off in order to deduct bad debts as an expense for determining taxable income. [For more information, you can refer to IRS Publication 535, “Business Expenses” (2005), and pay particular attention to the post on business bad debts]