How to account for bad debt? This is a short but complete guide of the
terminology of bad debt accounting, illustrated with examples and journal entries. This video covers concepts such as direct
write-off, various methods to calculate the bad debt allowance, how bad debt write-off
and the bad debt allowance method relate, and as a bonus how bad debt accounting works
in the case of fraud in accounting statements. Let’s get started with a simple example,
and build up the discussion of bad debt with step-by-step examples. Let’s imagine a perfect world where every
customer always pays his bills. In that case, you need just three accounts
to record the journal entries for the billing and collection cycle: revenue in the income
statement, accounts receivable on the balance sheet, and cash on the balance sheet. If ABC Company bills \$100 in revenue to customers
in year 1, and customers pay \$90 of this \$100 during that same year 1, then the ending outstanding
accounts receivable balance at the end of the year is \$10. In the management reporting of company ABC,
the Days Sales Outstanding metric (how long it takes on average for a customer to pay)
would be this outstanding accounts receivable balance of \$10 divided by full year revenue
of \$100, times 360 days, is 36 days DSO. Maybe the terms in contracts with customers
are 30 days, and customers are on average 6 days late in paying, but every customer
pays in the end. Second year. Revenue of \$200, collections of \$190. The ending accounts receivable balance equals
the opening balance of \$10 (carried over from last year), plus revenue of \$200, minus collections
of \$190, is \$20. Days Sales Outstanding is stable at 10% of
revenue, or 36 days. Third year. Revenue of \$300, collections of only \$280. The ending accounts receivable balance equals
the opening balance of \$20 (carried over from last year), plus revenue of \$300, minus collections
of \$280, is \$40. Days Sales Outstanding deteriorates to 48
days. This is where management starts wondering
what is going on, as this DSO increase is very large versus previous years. The terms in the contracts with the customers
have not changed, so there must be an issue with late payment. They start investigating, and find out that
one of their customers, XYZ Corporation, has gone bankrupt, and none of the \$10 receivable
that ABC had on XYZ is recoverable. This is where ABC Company would book a direct
write-off. As there is no hope of collection, the accounts
receivable asset is removed from the balance sheet by crediting the Accounts Receivable
account. The debit of the journal entry goes to Bad
debt expense in the income statement. A very painful step to take for the management
of ABC Company, which is partially due to their reactive view on receivables collection,
and the naïve assumption that every customer always pays. They decide that going forward, ABC Company
will be more prudent and book an allowance for doubtful accounts on a periodic basis,
based on expected credit losses. The debit of the journal entry goes to Bad
debt expense, the credit to a balance sheet contra account called Allowance for doubtful
debt. There are several ways to calculate and record
this allowance. The first method is called the income statement
method, as it looks at income statement data to record the allowance for doubtful debt. Based on the revenue of \$400 in year 4, and
historical write-offs of around 2% of sales, management decides to put aside \$8 in the
Allowance for doubtful debt account. The impact of recording the allowance on the
income statement is: in revenue the full amount billed is recorded, the estimated credit loss
gets recorded in Bad debt expense, which is an account in the category of selling, general
and administrative expenses or SG&A. On the balance sheet, once we have recorded
cash collections for the year, we can calculate Accounts Receivable, net of allowance for
doubtful accounts. \$30 opening balance for the year + \$400 sales
for the year – \$390 collections – \$8 doubtful debt allowance=\$32 net accounts receivable
balance. The second method to calculate the Allowance
for doubtful debt is the balance sheet method, as it looks at balance sheet data to record
the allowance for doubtful debt. \$30 opening balance for the year + \$400 sales
for the year – \$390 collections=\$40 gross accounts receivable balance at year end. Management reviews this \$40 outstanding balance in detail, and estimates that 20% is considered uncollectible. Debit Bad debt expense by \$8, credit the balance
sheet account Allowance for doubtful debt by \$8. What are the ways to estimate this? You could book the allowance (and related
Bad debt expense) based on a specific review of known troubled accounts, in other words
you put specific names of specific customers and specific open balances on your list for
the bad debt accrual. You could also take a more general approach,
and assign a % probability of the open accounts receivable balances not getting collected. For example, X% allowance for accounts between
0 and 30 days overdue, a higher percentage of Y% for accounts between 30 and 60 days
overdue, and a yet higher percentage of Z% for accounts more than 60 days overdue. Or a hybrid method that combines the specific
and generic approaches. Whichever method you choose, support it with
data from historical experience of write-offs and any other industry- or country-specific
data. Now that an Allowance for doubtful accounts
is in place, an actual write-off will not be as painful, at least not from the income
statement perspective. Let’s assume another customer goes bankrupt,
and there is zero hope of recovering any of the outstanding balance. It is therefore time to remove the asset from
the balance sheet by crediting the Accounts Receivable account for the \$5 that this bankrupt
customer will never pay, but this time the debit goes to the Allowance for doubtful debt
balance sheet account, not the Bad debt expense in the income statement! Before the write-off, the net accounts receivable
balance after allowance was \$32, and after the write-off the net accounts receivable
balance after allowance is still \$32. If a larger customer goes bankrupt, and the
Allowance for doubtful debt is not sufficiently high to cover the full amount, then \$8 of
the \$10 gets debited to the Allowance, and the remaining \$2 has to go to Bad debt expense
in the P&L. The opposite could also occur. If the Allowance for doubtful debt is not
at all or only partially needed to cover actual write-offs, then management could decide to
release part of the Allowance for doubtful debt back into the P&L, as a credit to Bad
debt expense. Obviously, the justification and calculation
for taking such a step should be well thought through and documented. Bonus tip. What if the accountant of ABC Company finds
out that the increase in DSO in year 3 that we discussed earlier was not caused by a real
customer not paying, but by the company overstating its revenue? If ABC Company has booked fake invoices to
artificially boost revenue, then that revenue will obviously not be collected as there is
no real customer to pay the invoices. In that case, a receivable write-off would
not be appropriate, but the company may get forced to reverse part of its revenue booking,
which lowers the revenue in the income statement as well as lowers the outstanding Accounts
Receivable balance. That should provide a good start to understand
the terminology of bad debt accounting, as well as examples and journal entries. I hope you enjoyed this short explanation
of bad debt accounting. If you enjoyed this video, then please give
it a like! On this end screen, there are a few suggestions
of related videos you can watch next. Please subscribe to the Finance Storyteller
YouTube channel! Thank you.