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Bad Debts Journal Entry

What is Bad Debt?

A company must decide what percentage of its receivables is collectable when it prepares its financial statements at the end of the fiscal period. The portion a business thinks will not be recouped called “bad debt expense.”

The two ways to record bad debt are direct write-offs and allowance methods.

What do you mean by Bad Debts Journal Entry?

Bad debt is a category of accounts receivable (AR) or the sum of money a client owes to a business. If the business doesn’t believe it could obtain the client’s payments, it is called bad debt in this case. 

The business records this uncollectible money as an expenditure on the company’s financial records whenever this occurs. 

The business cannot fully recover a debt, including

  1. Claims and disputes
  2. Insolvency
  3. Clients who refuse to pay

Bad Debts from a Business Perspective

In business terms, bad debts are expenditures, as there is zero probability of generating any revenue from these debts. 

What do they do with bad debts?

Businesses write the debt off to avoid overstating the worth of their current assets when filing taxes. Debt also helps them reduce their receivables’ reported balance because bad debts aren’t assets. The lower amount indicates a sound financial condition since the business can recover its debts successfully. 

A company uses two categories of accounts to document bad debts:

  1. Bad Debts Account
  2. Debtor’s Account (Borrower’s Identity)

Bad Debts Write-off Methods

Every business uses write-off methods to write off bad debts. These are the two accounting methods for recording bad debts.

Direct Write-off Method

When to use it

Direct write-off strategy recognises bad debt later. In this method, you must write off debts when your company considers your client’s bill unrecoverable, and you decide to mark it off as a debt.

Otherwise, your company will have vast accounts receivable totals, which overestimates the number of overdue customer bills. 

How to use it

As a supplier, you must credit the invoice value to the bad debt expenditure account when you feel the customer will not pay the bill. You must also debit the bad debt expenditure account in a general journal while you credit the accounts receivable. 

In addition, you may have to debit a relevant GST account to rectify previously calculated amounts on the invoice.

Provision for bad debt journal entry

When to use it

You must write off debts using this method when it becomes difficult or impossible for you to recover the debt. 

How to use it

You can change a bill’s value as a provision to your account. The journal entry for bad debts provision will then have a credit to your receivable account and a deduction to your suspense account. Similarly, reduce the GST in due accounts if you include GST in the initial bill.

Bad Debt Write-Off Methods: Analysis 

You must know that the direct write-off method delays finding your bad debts after the initial recorded sales time. Therefore, your company must wait months before writing off the debt and prefer the provisioning method to write off bad debts.

Types of Bad Debt

Here are the different types of bad debts:

Personal Loans

A personal loan is the sum of cash you borrow from a creditor to fund a personal project. The projects can be a large purchase, a venture, a trip, or healthcare expenses. They include borrowing costs that can change creditworthiness records, e.g. credit cards.

Range of loan rates: between 5% and 35%. 

Repayment period: payable in monthly payments

Most payments could take around 2-5 years, depending on the amount. However, you must pay back the loan at the earliest.

Credit Card Loan

A credit card loan refers to the sum due across all your credit cards, and this is bad debt.

Repayment period: as mentioned by the creditor and longer you take to repay the loan, the higher the interest rate. 

Range of loan rates: depends on the creditor.

Every cardholder should practice financial self-control by repaying any obligations on time to avoid incurring extra interest or charges.

Car Loans

A car loan is a loan a customer takes when purchasing a vehicle. 

Repayment period: they can pay the amount back as a downpayment and reduce the interest rates they owe.

So when considering this bad debt, you have to move the debt from the asset to the liability column to make the loan amount non-recoverable. 

Deals by Moneylenders 

Moneylender creditors can forgo the background investigation and credit history, making it more straightforward for you to get a mortgage. 

Repayment period: a brief period as specified by the moneylender

You must remember to settle this bad debt quickly as you have the cash since the debt’s borrowing costs add up quickly.

Payday Loan

A payday loan is a certain bad debt due to its lesser terms.

Range of loan rates: borrowing costs reach 400% 

The high-interest rates demand you to repay the loan early to prevent accruing debt and reduce your expenses.

Service Provider and Trader Non-payment

Your business can seek help from third-party collector services or agencies to reach out to your customers for payment retrieval. You can do this when your customer refuses to pay after purchasing goods or services. Otherwise, you may accumulate bad debt. 

With this service provider, you can remove bad debt from your financial records as it shows a history of timely payment recovery. You can also protect against non-payment of goods or services using trade credit insurance which covers your company from non-payment of invoices and bad debts.

Bad Debts and the Trial Balance

Is bad debt a credit or debit? 

Recording bad debt involves a debit and a credit entry. An offsetting credit entry makes a contra-asset account, referred to as the allowance for doubtful accounts. You can use debit note or credit note to settle existing debts.

In a balance sheet, you have a provision to reduce bad debt from debtors, and then you can view the net figure in the balance sheet.

While preparing your trial balance, you must always remember those bad debts are a loss to your company and should be limited. Therefore, it should be added to the loss side of the P&L account and reflected in the trial balance sheet as a bad debt entry recoverable from its profits.

When you feel like adjusting your bad debt expense, you must increase your bad debt expense account with a debit and decrease the accounts receivable account with a credit. However, before the process, you should be thorough about direct and indirect expenses.

Significance of Bad Debt Expense

Every business will eventually encounter a consumer who needs help paying their obligation. Hence the business must register a bad debt. Investors can assess a company’s financial success using these records.

If companies record bad debt expenses every time the company prepares their financial statements, there are a lot of benefits, such as:

  1. When a company decides to leave bad debt expenses out, it overstates its assets, and it could even overstate its net income.
  2. They can identify customers who default on payments more often than others. 
  3. Companies can use the information from the bad debt accounts to identify creditworthy customers and offer them discounts for their timely payments.

Although bad debts may be receivables that a business might find difficult to recover, they are a necessary component of business operations that provide credit sales. Therefore, you should have a bad debts journal entry to record all the bad debts. 

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FAQs on bad debt journal entry

How do I apply the direct write-off approach?

You must discover the bad debts and attempt to gather them before you write them off.

Do bad debt recoveries count as revenue?

The recovered bad debts do indeed count as revenue.

What are the procedures for writing off bad debt?

- Direct write-off Method
- Provision Method

Where are bad debts recorded?

The income statement includes bad debt expenses, often categorised as sales and general administration expenses.

Is bad debt written off an asset?

Bad debts are removed as assets from the balance sheet because a company cannot expect to recover this payment while writing debts off. However, when a company writes down a bad debt, some of the bad debt value remains as an asset because the company expects to recover it.

What are bad debts in trial balance?

Writing off an irrecoverable debt means taking a customer's balance in the receivables ledger and transferring it to the profit or loss statement. Then, in the P&L statement, you can add it as an expense because the balance has proved irrecoverable.

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