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written by | August 2, 2022

What Is the Journal Entry for Bad Debts?

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It's vital that a company accurately records any money it is unable to collect from clients on its balance sheet. This guarantees reliable financial statements and a sound economic atmosphere. You may create a dependable journal entry by understanding how to enter this kind of data in your financial report. Knowing how to record a bad debts journal entry is a crucial task when running a business.

Did you know? In the income statement, bad debt expenses are generally classified as sales and general administrative expenses.  

What is Bad Debts Journal Entry?

Bad debt is a category of accounts receivable (AR), which refers to the sum of cash that a client owes to a business. If the business doesn't believe they could obtain the payments from the client, it refers to as bad debt in this case. They record the uncollectible money as expenditure on company financial records whenever this occurs. There are numerous reasons why a business cannot fully recover a debt, including claims and disputes, insolvency, and clients who simply refuse to pay. 

A business views bad debts as expenditures since there is little probability of generating any revenue from these debts. Writing it off enables the business to avoid overstating the worth of its present assets when filing taxes. Writing down bad debts enables the business to lower the reported balance of its receivables because bad debts aren't assets. A lower amount of accounts receivables indicate sound financial condition because they reflect that the business can successfully recover its debts. There are two accounts, "Bad Debts Account" and "Debtor's Account (Borrower's Identity)," which the company uses in accounting and journal entries to document bad debts.

Also read: Accounting Period - Definition, Types & How Does an Accounting Period Work?

Bad Debts Journal Entry Examples

Let us look at an example of a bad debt journal entry.

Example 1:

Independent Graphic Designers provide billboards, emblems, apparel designs, and some other services for their customers. They have a long-standing client who abruptly stopped paying their ₹400 bill for the most recent services. They contacted the client to find out why they had not yet received the money. After four months, they regrettably discover that the user's mobile number is no longer functional. They were doubtful of recovering the debt and decided to mark it as bad debt. The bad debts written off journal entries read as follows because they believe it is doubtful they will be able to obtain the payment:

Account Name

Debit

Credit

Accounts receivable

 

400

Bad debt expenses

400

 

Total

400

400

Example 2:

A car dealer finds out that three of the clients have not repaid their car loans. The dealer records the accounts as bad debts after using collection support and yet is unable to recover the funds. The three clients owe ₹10,000, ₹50,200, and ₹30,000, respectively, for a cumulative value of ₹90,200

The bad debts journal entry will appear as follows:

Account Name

Debit

Credit

Bad debts expense

90,200

 

Accounts receivable

 

90,200

Total

90,200

90,200

Bad Debts Write-off Methods

Businesses use either the direct write-off approach or the allowance technique to write off bad debts. The very first strategy recognises bad debt later. Whenever a company considers a client's bill unrecoverable and marks it as bad debt, it must be written off. If not, the company will have excessively large totals of accounts receivable, which overestimates the number of overdue customer bills. Below are the two accounting methods for recording bad debts.

  • Direct Write-off Method

Whenever it seems that the customer will not pay the bill, the supplier may credit the value of the invoices towards the bad debt expenditure account. They debit the bad debt expenditure account in the general journal while they credit the accounts receivable. They will also need to debit the relevant GST account to rectify any previously calculated amount on the invoice.

Also read: Tax Accounting - Definition and Types of Tax Accounting

  • Provision Method

The seller may charge the bill's value as a provision to an account for doubtful debts in case it becomes difficult or impossible to recover the debt. The journal entry results in a credit to the receivable account and a deduction to the suspense account. Similarly, if the seller includes GST in the initial bill, it could be essential to reduce the GST in due accounts.

Analysis of Bad Debt Write-Off Methods 

In either scenario, the company creates a credit memo in the accounting system that precisely counters the target bill when a bill is clearly written off. The provision method is the preferred method for writing off bad debts. Whereas the direct write-off method delays finding bad debts after the time of the initial recorded sales. As a result, a company has to wait for months before writing off the debt. Thus, it results in a discrepancy between how and when the company records the income and how it associates with bad debt.

What Are Some Types of Bad Debt?

There are many types of bad debts to take into account, such as

  •  Personal Loan

A personal loan is a sum of cash that you take from a creditor to fund a personal project, such as a large purchase, a trip, a venture or healthcare expenses. Personal loans include borrowing costs, like credit cards, and these percentages can change creditworthiness records. The range of these loan rates is between 5% and 35%. Personal loans are payable in monthly payments, typically. Although most payments could take around 2-5 years depending on the amount, it's imperative that a person pays back the loan at the earliest for this kind of bad debt.

  •  Credit Card Loan

Customers commonly receive credit cards from creditors to buy things. Such cards might charge higher interest, depending on the creditor. It means the longer the customer takes to repay the loan, the higher the interest rate will be. As a result, a customer might end up paying a higher interest. The sum of debt which is due across all your credit cards is bad debt. This implies that cardholders must practice financial self-control by staying within their limits and repaying any obligations on time in order to avoid incurring extra interest or charges.

It means that the longer the customer takes to repay the loan, the higher the interest rate will be. As a result, a customer might end up paying a higher interest.

Also read: What is Fair Value Accounting? Fair Value Meaning, Calculation & Advantages

  •  Car Loans

Customers commonly take a car loan when purchasing vehicles. They can pay back an amount as a downpayment to reduce the interest rates they owe on the car. When a car loan lender considers an amount as bad debt, the lender moves the debt from the asset to the liability column. Thereby, the loan amount is deemed non-recoverable to the lender. 

  •  Moneylender Deals 

This kind of creditor can forgo the background investigation and credit history, which will make it simpler for you to get a mortgage. Because you typically repay the debt within a brief period, this type of bad debt has borrowing costs that add up fast. You must settle this bad debt as quickly as you have the cash.

  •  Payday Loan

Since they have lesser terms and frequently have borrowing costs that can reach 400%, payday loans are a special kind of bad debt. Rising interest rates encourage the customer to repay the loan early, in addition to service penalties. Doing so could prevent accruing debt and significantly reduce your expenses.

  • Service Provider and Trader Nonpayment

The seller may accumulate a bad debt when the customer refuses to pay after purchasing goods or services. In such cases, as a business, you may seek help from third-party collector services or agencies to reach out to the customer for payment retrieval. With this, businesses can take advantage of removing bad debt from their financial records as it shows a history of timely payment recovery. Non-payment of goods or services can also be protected by using trade credit insurance. This insurance protects the company from non-payment of invoices and bad debts. Using these details, investors assess a company's profitability and reputation.

Also read: Different Types of Accounts in Accounting - 3 Types of Accounts

Conclusion

For businesses that provide credit sales, bad debts are indeed a necessary component of operations. These may be receivables that a business might find difficult to recover. Therefore, a bad debts journal entry is very essential to record the same. Bad debts can have a negative effect on a business since they drive up costs while reducing assets. 

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FAQs

Q: Does recovery of bad debts count as revenue?

Ans:

Yes, the bad debt recoveries count as revenue.

Q: How can I use the direct write-off method?

Ans:

  • Find the bad debts.
  • Before writing them off, try to collect them.
  • Note them on your balance sheet.

Q: What are the bad debt write-off methods?

Ans:

  • Direct write-off Method
  • Provision Method

Q: Why are bad debts important?

Ans:

At certain points, every company will have a customer that cannot pay the debt, and the company will be required to record a bad debt. These records help investors to evaluate a company’s financial performance.

Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.