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Choosing Bad Debt Methods [Basic Accounting]

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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.

 

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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:

[Debit]. Bad Debts Expense = $18,500
[Credit]. Accounts Receivable = $18,500

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]

12 Comments

12 Comments

  1. travelia

    Apr 17, 2009 at 11:05 pm

    Hi Putra,
    It is great info. But, I’ve been looking for the information, what is the normal term to write off customer account? Is that 60days an enough time to give a grace period to customer to pay otherwise we write off or we we need to give more time like 90/120/150/180?

  2. Joseph

    Jun 25, 2009 at 4:31 am

    Hi Putra
    I think the allowance method is not allowed under IAS 39, but allowed under US GAAP. Under IAS 39, two levels of assessment needs to be done: specific and collective. Collective assessment is similar to the allowance method that you described, except that debts identified as impaired under the specific assessment will be excluded from the collective assessment.

  3. Putra

    Jun 25, 2009 at 11:14 am

    Travelia,

    There is no such normative-term-based [specific time span] to write-off customer’s account. Legally, it is until a court legally stated the customers are qualified for bankcruptcy. Ofcourse, that is not a business common sense to keep such bad debt on the book forever. It’s not only a cost to maintain the account, unless if the account properly isolated, it will be a burden for the management when temtping to perform liquidity analysis.

    The financial executives [management] should come up with a realistic proposal to the shareholders for the write-off, otherwise it will be endup with rejection.

  4. Putra

    Jun 25, 2009 at 11:23 am

    Yo Joseph!,

    No, it is not allowed both under IAS 39 [=IFRS] and IRS and yes it was allowed under US GAAP. Since we are now under IFRS, and we can’t forget about IRS, so consider it is completely not allowed any longer 🙂

    Cio,

  5. shaharyar

    Aug 13, 2009 at 4:44 pm

    plz solve this question in send me my email as soon as possible.. qusetion is the income statment approach to estimating uncllectible accounts expense is used by burgess wholesale. on march 31 the firm had accounts receivable in the amount of rs 630,000 the allowance for doubtfull accounts had a crdit balance of rs 3950 n unclollectible accounty expenses one half of 1% of the net sale made an account receivable from conrad stern of rs 3110 was derermined … prepar journal etries

  6. ANWAR SADIQUE

    Oct 1, 2009 at 6:51 am

    kindly help me regarding the accounting entries in the case of amount of bad debts recovered-under write of method and allowance method

  7. Putra

    Oct 2, 2009 at 1:24 pm

    Anwar,

    Under allowance method it is recovered with a two step entry:

    Step-1. Recover the bad debt expense by debiting the allowance account:

    [Debit]. Bad Debt [Uncollectible] Allowance
    [Credit]. Bad Debt Expense [Bad Debt Recovery]

    Step-2. Recognize the cash received by crediting [reducing] the allowance account:

    [Debit]. Cash
    [Credit]. Bad Debt [Uncollectible] Allowance

    The two step entry is to show the movement for the shake of consistency concept.

    Under the “Write-off” method, you have two choices:

    Choice-1: Recognize it as “other income”:

    [Debit]. Cash
    [Credit]. Other Income

    Choice-2:

    [Debit]. Cash
    [Credit]. Bad Debt Recovery

    However if the receivable/loans acquired from other company [party] and the write-off happened before the acquisition, then you may not choose the second option. Why? Because you acquired the receivable/loans at the net value.

  8. Christine Mukulu

    Oct 5, 2010 at 8:05 am

    Is it OK for the financial Statement to have bad debts presented on the face under IAS 39?

  9. shushi tofunaga

    Apr 7, 2011 at 1:27 pm

    thai accounting nowsaday, do we still have to teach the using of allowance method for bad debt. When do we use impairment loss with the bad debts expense.

  10. jorge perez

    Mar 3, 2012 at 5:54 pm

    het there Putra.
    my question is the following: a company has $15 millions on doubtful debts provisions but $6million were overstated and only $1 million were wrote off. in the same yearthis company re valued its shares by $9 million plus 4.5 of the consolidated profit from the period 1999-2000 was transfered into the general reserve. the following year the doubtful debts provision incrase to $17.5 million and only $650,000 were wrote off.
    What is the company trying to do with this movements? what are the best relevant priciples to apply in this case? thank you ver much!!

  11. Steve

    Mar 19, 2012 at 4:18 pm

    Dear Putra,

    Why would a company use a hybrid formula for determining their bad debt reserve(using a mix of a specific reserve and a general reserve)? Pros, Cons?

    Which method would that fall under?

    Thanks

  12. Lauren

    Feb 27, 2015 at 1:32 am

    Assuming we used the direct method to write off/ subsequently recover bad debts…..

    Write off of bad debt:
    Dr. Bad Debt Expense
    Cr. A/R
    Subsequent Collection of bad debt:
    Dr. Cash
    Cr. Income

    Company X was acquired after the write off, but then subsequent cash collection should hit the new companies liability account to previous shareholders. How should I record this?

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