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. These issues arise in every industry—retail, manufacturing, professional services, construction, trading companies, and even government-linked corporations—where goods or services are supplied on credit terms. Because credit plays a major role in economic activity, the ability to manage, recognize, and report bad and doubtful debts is fundamental not only for internal accounting but also for lenders, auditors, tax authorities, and investors.
This article greatly expands on the original overview, providing deeper explanations, real-world business scenarios, global accounting perspectives (IFRS, GAAP, and common business practice), and practical illustrations. Understanding their accounting treatment ensures accurate financial reporting and efficient credit management. Below are practical examples of bad and doubtful debts and their journal entries, presented with extended context and applied knowledge.
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., after making several follow-up attempts, sending reminders, negotiating revised terms, and issuing a final demand notice, determines that the amount is uncollectible and writes it off as a bad debt.
This scenario is extremely common in modern commerce. Businesses often face situations where customers simply disappear, close their operations, or enter insolvency procedures. Under IFRS 9 (Financial Instruments), entities must reassess the recoverability of receivables and recognize credit losses immediately. Under GAAP, the direct write-off method is sometimes used by small entities, but most businesses use the allowance method.
Accounting Treatment
Since the debt is now confirmed as uncollectible, XYZ Ltd. must remove it from accounts receivable and record it as an expense. The financial impact is two-fold:
- The accounts receivable balance decreases.
- The income statement reflects a bad debt expense, lowering net profit.
Journal Entry (Writing Off Bad Debt):
Debit: Bad Debt Expense $5,000
Credit: Accounts Receivable (John’s Electronics) $5,000
Broader Discussion: Why the Write-Off Matters
Writing off a bad debt does not necessarily mean the business has failed in credit management. It often reflects responsible accounting practice by presenting a realistic picture of receivables. If bad debts are not written off:
- The balance sheet becomes overstated.
- The company appears more profitable than it actually is.
- Stakeholders may form inaccurate judgments about liquidity and performance.
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. This could occur because:
- A liquidation process resulted in partial settlement.
- The customer resumed operations.
- Collectors were able to recover part of the amount.
- Legal enforcement produced results.
Journal Entry (Bad Debt Recovery):
Debit: Cash/Bank $2,000
Credit: Bad Debt Recovered $2,000
Bad debt recovery is always recorded as income because the original write-off has already been expensed in past financial periods. This approach ensures the financial statements reflect the unexpected gain appropriately.
2. Example of Doubtful Debts
Scenario
ABC Enterprises has accounts receivable worth $100,000. Based on past experience, industry risk, customer payment patterns, and current economic conditions, 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.
This estimate-based approach follows the prudence concept: anticipated losses are recognized early. Under IFRS 9, businesses must recognize an Expected Credit Loss (ECL) even on receivables that currently appear collectible.
Accounting Treatment
At the end of the accounting period, the business records the estimated doubtful debts as an expense. This ensures that financial statements reflect:
- A realistic value of accounts receivable.
- A more accurate profit figure.
- Improved corporate governance and credit risk transparency.
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. This demonstrates the purpose of maintaining a provision: to absorb future credit losses without affecting current-year profitability disproportionately.
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. Provisions must always be reviewed annually to reflect:
- Improved customer conditions
- Economic recovery
- Reduced exposure to risky customers
- Updated credit policies
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
Before offering credit, companies must assess customer creditworthiness through:
- Credit bureau reports
- Trade references
- Bank statements
- Past payment behavior
B. Implementing Payment Reminders
Automated reminders, follow-ups, and escalation procedures help maintain timely collections and reduce overdue accounts.
C. Offering Discounts for Early Payments
Many businesses offer settlement or cash discounts to encourage early payments. This accelerates cash flow and reduces the risk of receivables aging into doubtful or bad debts.
D. Using Collection Agencies
For difficult cases, professional debt collection agencies or legal teams may assist in recovering unpaid amounts. These external resources specialize in negotiations, settlement arrangements, and legal enforcement.
E. Strengthening Credit Policies
Clear credit terms, penalties for late payment, interest on overdue accounts, and customer segmentation help reduce default risk.
F. Using Aging Analysis Reports
An accounts receivable aging schedule allows businesses to categorize receivables by how long they have been outstanding (30, 60, 90, 120+ days). This helps identify emerging risks early.
G. Monitoring Economic Conditions
Macro-economic events—recessions, currency volatility, rising interest rates—can increase doubtful debts. Proactive monitoring helps businesses adjust credit policies accordingly.
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, adjusting provisions based on realistic estimates, and strengthening follow-up mechanisms, businesses can protect themselves from unexpected financial losses and maintain financial stability. Proper accounting treatment under IFRS and GAAP ensures transparency, enhances investor confidence, and supports long-term business sustainability.
✓