What is Bad Debt and How to Calculate Bad Debt Expenses?
4 November 2022
Bad debt is regarded as the accounts receivable for a business/organisation that has become uncollectible due to non-repayment issues from the customer’s end. Such a situation might arise when a customer cannot pay the outstanding sum due to financial difficulties or chooses to deny the payment over a disagreement. Irrespective of the reason, bad debtis recorded as a provision for credit losses in a company’s financial statements.
Read on to know ways to calculate bad debt and how to report it in accounting statements.
What is a Bad Debt?
Bad debt is the amount of debt that becomes irrecoverable because the customer is unable to repay it. Therefore, entities record the same uncollectible amount as a bad debt.
It is a type of unforeseen expense for the creditor company. An entity may offer goods or services on credit to its customers. However, if customers delay or miss out on said payments, this payment is recorded as an expense in the company’s income statement.
There could be several reasons for missing out on the payments like financial difficulty, customers wilfully engaging in fraud, etc.
Why Does Bad Debt Occur?
Bad debt can occur due to various reasons, the popular reason being financial difficulties from the customer’s end. Apart from this, a few other reasons that can lead to bad debt include:
If the debtor is refusing to pay the debt
When you are unable to collect the sum due to some reason
In case of any dispute between you and the customer over product or service quality, price or delivery
What is Bad Debt Provision and Why is It Important?
While running a business, you may come across customers unable to repay their debts. Having said that, you cannot be sure which debt will turn into bad debt. Thus, the accounting method to record such debt starts with an estimate. This estimate is known as bad debt provisions or provisions for doubtful debts.
You need to record the provision for bad debt in a contra-asset account, which is referred to as allowance for bad debts, allowance for credit losses or allowance for doubtful accounts on the company’s balance sheet.
You must also record these provisions separately so that your balance sheet remains organised and clean.
To understand the provisions for bad debts, it is crucial to know that there are various ways to make the estimate. Some of these methods are a legal requirement, whereas others are simply strategic preferences. Thus, ensure to research the standards for provision as per your locale.
One of the most efficient ways to provision for doubtful debts is by understanding the historical performance of loans in a particular population. This will help create bad debt estimates based on previous trends, thus helping you to make well-informed decisions that are backed by concrete data.
Another convenient provisioning strategy is to overestimate bad debt provision. This method can prove to be extremely helpful during times of uncalled-for crises. If your business’ bad debts exceed the initial estimates, you will have to report it as bad debt expense in your income statement. By taking a more conservative path, you can avoid paying those expenses.
How to Calculate Bad Debt Expenses?
You can calculate bad debt expenses through two methods which have been discussed below:
Direct Write-off Method
In this method, you need to write off the debt directly to the accounts receivable. Upon that, your company’s bad debt account is debited and accounts receivable are credited. However, the direct write-off method does not follow the matching principle for accrual accounting.
Per this principle, individuals must record an expense during the transaction and not when the payment is made. If you follow this method, there is no formula required to calculate the bad debt as the actual value of the bad debts is recorded in the book of accounts as an expense.
The allowance method is ideal when a substantial amount of bad debt money is involved. In this method, a company anticipates the emergence of bad debts and prepares accordingly for the situation.
To put the allowance method into practice, you must create an allowance for doubtful accounts. This is a contra-asset account, which reduces the loans receivable when you list both these accounts on the balance sheet. Upon making a sale, you should estimate bad debt and debit the same to the bad debtexpense account. This sum will get credited towards the allowance for doubtful accounts. When you wish to write off this debt, you need to debit your allowance for the doubtful accounts and credit the accounts receivables.
How to Estimate Bad Debt Expense?
Estimation of bad debts is one of the most important aspects of creating provisions for such debts. You can estimate bad debts in your company through the following methods:
Accounts Receivables Ageing Method
This method involves grouping receivable accounts depending on their age and then assigning a percentage on the likelihood of payment collection. This allocated percentage depends on the previous history of payment collections.
This percentage is then multiplied by the overall range of accounts receivables in the date range. The values are then added together to form the bad debt expense estimate.
Percentage of sales method
This method simply considers a period’s total sales and multiplies the value by a percentage. In this case too, the percentage depends on the company’s history of payment collection.
How to Report Bad Debt?
There are two methods of reporting a bad debt as discussed below:
Write-off is the traditional method adopted by companies to report a specific bad debt. Under this method, managers write off bad debts against specific receivable accounts. A particular amount from that customer’s account is recorded as a bad debt expense.
However, there can be issues like misreporting of income between corresponding accounting periods. Hence, companies can write off bad debts only for immaterial amounts. When recording the bad debt in the book of accounts, the bad debt expense has to be treated as a debit item, and the corresponding accounts receivable will be a credit item.
Under this method, companies estimate their bad debts for a particular financial year and record them in a separate account. This separate account is called allowance for doubtful accounts.
It is only a prediction or estimation of bad debts out of the total receivables for the year. You can use the percentage sales or receivables ageing method to estimate bad debts for the year. During the journal entry, the bad debt expense account is debited, and allowance for doubtful accounts is credited.
When these predictions or estimations indeed become a bad debt, another journal entry is passed, which debits allowance for doubtful accounts and credits the receivable account.
What is the Treatment of Bad Debt as per Accounting Standards?
You need to create a provision for bad debtby debiting the bad debt expense account and crediting the accounts receivable. Moreover, according to Accounting Standard 29 “Provisions, Contingent Liabilities and Assets”, you, as an assessee, must keep an account of the provisions that occur during the regular course of your business.
Nonetheless, since the IT department sometimes disallows these provisions, it leads to a difference in timing between the books of accounts and accounting books as per IT Act.
Thus, you will also have to create deferred assets or liabilities accordingly. Consider going down this route only when the timing difference in a transaction is temporary.
What is the Significance of Bad Debt Expense?
Similar to other accounting principles, a bad debtexpense allows a company to report its financial position accurately. When you are running a business, you might come across certain situations where a customer will refuse payment, leading you to create a bad debt expense. However, a substantial appearance of bad debt can disrupt your company’s financial health.
Thus, it is crucial for you to accurately time your company’s bad debts. Further, recording such instances will help you avoid similar situations in the future.
Moreover, bad debt expenses feature tax implications. Reporting a bad debt will increase your expenses and decrease net income. Thus, the amount of bad debt you report during a year will impact the tax amount for that period.
Good Debt vs Bad Debt
Here are some differences between the two types of debts:
You can consider expenses incurred on good debts as an investment.
You cannot consider bad debts as an investment as it doesn’t have any future value.
Individuals use this to finance those goods or services which will provide some value in future.
Borrowers use bad debts to finance their consumption requirements.
What to Know While Dealing with Bad Debt Expenses?
Bad debt expenses can become inevitable while running a business. Thus, it is necessary to maintain strong credit management policies and detect your company’s financial management as well.
Mentioned below are a few tips to follow while dealing with bad expenses:
You can protect your company against bad debt by sending a bad debt letter. If your client misses a payment deadline, send a bad debt letter immediately and collect the outstanding amount to prevent it from becoming a bad debt expense. However, ensure not to intimidate your customer. Instead, try to maintain a positive relationship.
Collection of debt requires substantial expertise, which some companies do not possess. If you struggle with understanding the aspects of bad debt, you can avail a trade credit insurance. With this insurance, your insurer compensates you with a said sum, which protects your company’s cash flow.
You can write off your company’s bad debt if you know the amount is irrecoverable. In this method, you will need to debit the bad debt account and credit the accounts receivable with the same amount.
Sometimes, companies sell products and services to customers on credit, expecting future payment completion. However, when this backfires, the company has to deal with bad debt. In addition to impacting the overall revenue of a company, bad debts also affect the cash inflow of a business. Accountants should assess all possibilities of recovering a bad debt while reporting it in the book of accounts.
Ans: After writing off bad debt and considering it unrecoverable, you can still recover it from a bankruptcy trustee or a debtor who has decided to make a settlement. However, you might be able to clear off the debt at a much lower amount. Note that in this situation, the payment will be partial.
Q2. How much deduction is allowed on bad debts?
Ans: According to Section 36(1)(viia) of the Income Tax Act, only financial institutions and banks are allowed to create deductions pertaining to provisions of bad debt. No other assessee is eligible to claim such deduction on bad debt provision. Additionally, the deduction limit can vary from one bank to another.
Q3. What is the tax deduction of bad debts for a discontinued business?
Ans: If your business was already discontinued before the start of the accounting year, you would not be eligible to claim bad debt as a deduction from the company’s profit. According to Section 36(2)(iii) of the IT act, if a bad debt is already written off, it is not allowed to be a deduction on the grounds that there are still possibilities for recovery.
Q4. What is deferred tax?
Ans: The tax that arises from timing differences in accounting is called deferred tax. In simple terms, it refers to taxes that are postponed to a certain date in the future. Deferred tax takes into account all timing differences, both permanent and temporary.
Q5. What is the timing difference in accounting?
Ans: The timing difference is the interval between the reporting of pre-tax book income and actual taxable income. It can either be temporary or permanent. Temporary timing difference is reversible in the short term. Meanwhile, you cannot reverse permanent timing differences in the long term.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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