Bad Debts Expense: Definition, Example and Accounting Treatment

Default on payments against a certain amount of credit taken in the past by businesses or individuals results in bad debts. Let’s understand the reasons behind this. The words bad debts are self-explanatory. This involves the failure on the part of the individuals or business enterprises that cannot repay the credit amount they took in the past. In the case of commercial businesses, it is considered a ‘credit loss’ by the financial lenders.

A business enterprise’s inability to repay the borrowed amount could be varied. It could be because of the financial losses it has incurred or the misappropriation of funds by someone in the management. It could also be due to some unforeseen contingency that the business had not anticipated. In the case of individuals, the reasons could vary from person to person. These could differ from mortgage to loss of job or payments made towards some contingency or simply the inability to repay.

Did you know?

Japan leads the list of having the maximum national debt in the world despite having a population of only ₹12.58 crores.

Bad Debts

You can never recover bad debts expenses from the individuals or the businesses who have obtained credit from banks or other financial lenders. They declare an incapacity to repay the credit amount. In the case of most businesses, the borrowing enterprise cannot repay for the goods and services taken on credit. In some cases, it is money borrowed for expansion plans. When the borrowers declare that they will not be able to make the payment, it becomes a case of bad debt, and for the lenders, it is considered a bad debt expense.

To understand the meaning of bad debts, you have to understand the meaning of credit. Credit is offered in the form of loans to businesses or individual entrepreneurs, or even individuals for various reasons. Financial institutes and banks lend money after scrutinising the credit ratings of all borrowers. However, the question of risk always persists. There have been innumerable cases where borrowers have failed to repay the amount borrowed, and the lenders know that there are no chances of recovering the credit amount.

The credit amount is finally declared as a bad debt. Bad debts are always written off, though if the borrowers’ fortunes change, the lenders have every right to collect the credit amount offered by them. Bad debts are costs that the money lenders incur as they are aware after the borrowers declare themselves as broke or loss-making entities. A bad debt expense is categorised as an administration or a sales expenditure and is reflected in the income statement of the account books of the lenders.

Also Read: What is Accounts Receivables?

Accounting Treatment for Bad Debts

When you record a bad debts expense in your book of accounts, it has to be debited, and you must credit doubtful accounts. There are two accounting processes to write off bad debt expenses. These are the direct write off and the provision processes. The direct write-off method has no contra asset account for recording bad debt expenditures. A credit balance always prevails in a contra asset. In simple words, you will always find a debit, or positive, balance in a regular asset account. You will find a credit or negative balance in a contra asset. Termed as a negative account, the contra asset is used in the accounting process that involves double-entry. It is linked to an account with a reporting balance opposite to its own. This is intended to reduce the said amount of the regular accounts.

The direct write-off method – When lenders or sellers are absolutely sure that they have lost their money, they include the amount in the bad debt expense account. This becomes a debit entry in the said journal and a credit entry in the accounts receivable section. This way, the revenues are in sync with the said expenditures for a specific accounting timeframe.

The provision or allowance method – The end of every fiscal year involves an estimation of the probable receivables. These are collected in the said provision or allowance account. The said amount is deducted from the receivables every year. This involves making a debit entry in the account of bad debt expense and credit to the account of bad debt provision, the latter being a contra account (accounts receivable). Lenders or sellers can include the bad debt amount as a provision of losses in the accounts receivables. These appear as operating expenses on the income statement of the organisation. Once you know the borrower won’t repay the credit amount, you will make a credit memo for the same amount in the accounting software. This will reduce the bad debt account with a debit entry and the amount in the accounts receivable, made possible with a credit entry. The entire process is to offset the said accounts in the balance sheet so that the income statement is not negatively impacted. Every time businesses make their financial statements; they should make an entry of all the bad debt expenses in detail. If they don’t, it can be misconstrued that the assets of the business and the net revenues are exaggerated. Such detailing also assists the firms to understand clients who default consistently on their credit payments.

Example of Bad Debts

There are many examples of bad debts in India and across the world. Some of the most common ones are as follows:

• Credit cards
• Vehicle loans
• Mortgages
• Individual or personal loans

A general example of bad debts is as follows:

XYZ business makes a sale of 10,000 mobile phones to a retail outlet on the basis of a credit of 180 days. XYZ makes an entry in its accounts receivables. This is done in its respective balance sheet. At the end of 180 days, XYZ understands that the retail outlet has incurred losses and cannot pay the said credit amount. This is known as bad debts expenses.

Many Indian corporates are known to have been defaulters of many debts. Given below are some names alongside the corresponding amounts of their debts. 

Bad Debts Expense in Financial Statement

Bad debts expense are always categorised as administration expenditures, and they can also be categorised as distribution and sales expenditures. For any organisation to get an insight into its probable bad debts, it should understand the percentage of the bad debt. The formula for the same is

Total amount of bad debts / Total amount of credit given = Percentage of bad debt

If e.g., a business has provided a credit of ₹ 6,000 crores in a financial year, and its borrower has not been able to pay ₹ 4,000 crores.

Its percentage of bad debts will be 0.67% – (₹ 4000/₹ 6000)

Also Read: Trial Balance: Rules Explained With Examples

Example 1:

An individual borrowed ₹ 1,00,0000 on June 1, 2020. The person has to repay the said amount by December 1, 2021. Since this is a short-term loan, the lender does not charge interest. When the said individual defaults, the lender will make a journal entry to state the bad debt in the following manner:

Now, let’s suppose the person is able to pay the entire amount on February 1, 2021, then the business will record a journal entry for that fiscal year ending as follows:

In the first entry, the bad debt is written off. This is done by making an increase in the accounts receivable and reducing the bad debts expense, i.e., credit for the amount that is received. The second entry details the amount which is received in cash, i.e., increase in the debit and decrease in the (credit) of the accounts receivables by ₹ 1,00,0000.

Conclusion

The details of this article inform you about the bad debts expense with examples. This article also states the accounting treatment of bad debts in journal entries. It is mandatory to account for these expenses as otherwise, the profits of the business in question can be overestimated. 
Follow Legal Tree for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.