Bad and doubtful debts are common financial concerns for businesses that offer credit sales. While bad debts refer to amounts confirmed as uncollectible, doubtful debts are estimated losses that may occur in the future. Understanding their accounting treatment ensures accurate financial reporting and efficient credit management. This article presents practical examples of bad and doubtful debts and their journal entries.
1. Example of Bad Debts
Scenario
A company, XYZ Ltd., sells goods worth $5,000 on credit to a customer, John’s Electronics. After several months, John’s Electronics goes bankrupt and is unable to pay the outstanding balance. XYZ Ltd. determines that the amount is uncollectible and writes it off as a bad debt.
Accounting Treatment
Since the debt is now confirmed as uncollectible, XYZ Ltd. must remove it from accounts receivable and record it as an expense.
Journal Entry (Writing Off Bad Debt):
Debit: Bad Debt Expense $5,000
Credit: Accounts Receivable (John’s Electronics) $5,000
Bad Debt Recovery
One year later, XYZ Ltd. unexpectedly receives $2,000 from John’s Electronics as a partial payment of the previously written-off bad debt.
Journal Entry (Bad Debt Recovery):
Debit: Cash/Bank $2,000
Credit: Bad Debt Recovered $2,000
2. Example of Doubtful Debts
Scenario
ABC Enterprises has accounts receivable worth $100,000. Based on past experience, the company estimates that 5% of receivables may become bad debts in the future. To reflect this possible loss, ABC Enterprises creates a provision for doubtful debts.
Accounting Treatment
At the end of the accounting period, the business records the estimated doubtful debts as an expense.
Journal Entry (Creating a Provision for Doubtful Debts):
Debit: Bad Debt Expense $5,000
Credit: Provision for Doubtful Debts $5,000
Writing Off a Specific Doubtful Debt
A few months later, a customer, Peter’s Furniture, with an outstanding balance of $2,000, is confirmed as bankrupt. The company decides to write off the debt using the existing provision.
Journal Entry (Writing Off a Doubtful Debt):
Debit: Provision for Doubtful Debts $2,000
Credit: Accounts Receivable (Peter’s Furniture) $2,000
Adjusting the Provision for Doubtful Debts
At the end of the next accounting period, ABC Enterprises reassesses its doubtful debts and estimates that only $3,500 is required instead of the previous $5,000. The provision is reduced accordingly.
Journal Entry (Reducing Provision for Doubtful Debts):
Debit: Provision for Doubtful Debts $1,500
Credit: Bad Debt Expense $1,500
3. Differences Between Bad Debts and Doubtful Debts in Practice
| Aspect | Bad Debts | Doubtful Debts |
|---|---|---|
| Definition | Confirmed as uncollectible and written off. | Estimated potential loss that may become bad debt. |
| Accounting Treatment | Recorded as an expense and removed from receivables. | Recorded as an estimate and deducted from receivables. |
| Impact on Financial Statements | Immediately reduces accounts receivable and net profit. | Appears as a provision reducing net receivables. |
| Reversal Possibility | Cannot be reversed unless recovered. | Can be adjusted based on reassessment. |
4. Managing Bad and Doubtful Debts
A. Conducting Credit Checks
Assess customer creditworthiness before offering credit to minimize default risk.
B. Implementing Payment Reminders
Sending automated reminders encourages customers to pay on time.
C. Offering Discounts for Early Payments
Providing small discounts motivates customers to settle debts quickly.
D. Using Collection Agencies
For difficult cases, professional debt collection agencies can help recover unpaid amounts.
Ensuring Financial Stability Through Proper Debt Management
Bad and doubtful debts impact financial performance, making it crucial for businesses to account for them properly. By implementing strong credit policies, regularly monitoring receivables, and adjusting provisions based on realistic estimates, businesses can protect themselves from unexpected financial losses and maintain stability.