Accounting for bad debt
Customer debt is cash owed to the business and a bad debt is money owed to the business that is considered to be irrecoverable or uncollectable. So, how does a business get in to this situation and how does a bad debt arise?
Cash is the life blood of a business and without it the business will fail. It is important all cash owed to the business is collected in a timely manner.
Not all retail businesses are in the position where they can demand payment for goods upfront or on delivery of the product. Similarly, not all service businesses are in the position where they can demand upfront payment of the provided services or the date the services are provided. In order to generate custom these businesses have to advance credit to customers credit in order to gain market share. When customers are advanced credit they become a debtor of the business.
A genuine bad debt, i.e. an amount that will not be received, must be provided for in the financial records. At the time the goods or services were supplied the double entry was to credit sales (in the profit and loss account) and debit a debtor account in the balance sheet. When there is a bad debt the debtor has to be wiped from the debtor account, as it will not be recovered. The rules of double entry states there is a corresponding debit for every credit, therefore when the debtor account is credited we need to post a corresponding debit to the profit and loss account. Many people would argue the bad debt debit is posted to the sales account, as if the sale never took place, however this treatment is not correct. The bad debt should never be posted to the sales account as a way of “reversing” the sale as the sale did actually take place, regardless of whether the debtor settled the outstanding monies due or not.
When writing the debtor off the balance sheet and posting the bad debt transaction to the financial records, the double entry is to credit the debtor on the balance sheet and debit a bad debt expense in the profit and loss account. The correct treatment is to treat the bad debt as an expense and not reverse it against the sales account since netting it off against sales is not permitted under accounting standards.
A genuine bad debt is referred to as a specific bad debt since it can be allocated to specific debtor and specific sales transaction. A specific bad debt is a tax deductible expense that is used to reduce the business’ taxable profits.
There are times when a business owner cannot definitely say whether there is a bad debt expense or not, a situation that occurs when the debtor may or may not pay the outstanding amounts due. For example, the debtor may have had a change in circumstances. The debtor may be falling on hard times or being threatened with court proceedings amongst many other scenarios, which may result in the debtor failing to have the money to pay off the outstanding debt. Alternatively, the circumstances may have no effect on the debtor’s ability to settle the debt. Where the business owner has a suspicion the debtor cannot pay the outstanding monies due a “potential” bad debt provision is needed in the accounts in accordance with the prudence concept.
When recording a potential bad debt the double entry is to debit a bad debt expense account in the profit and loss account and credit a bad debt provision account in the balance sheet. The double entry treatment is similar to that of a genuine bad debt it’s just that the credit is not allocated against a specific debtor account.
Unlike a specific bad debt, a potential bad debt expense is not a tax allowable deduction therefore it cannot be deducted from the business’ profits when calculating the taxable profits. This needs to be borne in mind before calculating the business tax liability and filing an incorrect tax return.
A bad debt transaction is an accounting entry, as opposed to a book keeping entry therefore a bad debt review is usually dealt with by the accountant when preparing the year end accounts. Despite this, it is advisable to keep a close eye on the debtor accounts and provide for the bad debt as it is identified. Debt collection is an important business function that should not be taken lightly.
Bad debts are often very expensive for a business. As well as the loss of the retail value of the product or services provided there are other costs incurred such as legal fees in pursuing the bad debt. All businesses should have an account receivable department and a bad debt policy to monitor and control bad debts for effective cash management and to reduce the chances of a bad debt happening in the first place.