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we’re going to learn a concept that is the bad net reserves or the allowance for
the bad debt expenses let’s try and understand in the detail format as you
can see over to hear detail of the shutterstock.inc consolidated financial
statement and we have the detail of the cash flow statement from the operating
activities there we have the data of the bad debt reserve as 1292, 2992 and 3175 or 6 it is for 2017 2016 and 2015
respectively this was just to show how or where exactly bad debt reserve is
been recorded it is also the part of the profit and loss
account where it is deducted from the bad debt and including in the data is also
it is how it takes into it it is taken into account now let’s understand what
exactly bad debt reserve is all about see bad debt reserve is an account which
offsets which offsets or reduces the account receivable that is your details
in the books of accounts so the thumb rule of the business in generating
profit so keeping nonprofit organization a side which works for the betterment of
the society all other organization works towards the earning or for profit you
can say that they earn for profit by means of increasing the revenue so we
all know that revenues earned by the organization is not settled by the cash
at the time of delivery of goods or computational service so there is a time
lag in between which we refer to as credit period example like you know the
great in company let’s say is involved in the business of manufacturing having
many heavy machinery which generally costs machinery that costs closely
to more than 100000 per piece and in this case
the payment terms defined as for the company policy was something like this
you know the advance was 10% on the acceptance of the order second the
release of the 30% of the payment on completion and 50%
of the work order after the certification of the completion there
was also a release of a 30% of the payment on delivery of the
machinery to the at the customers warehouse another clause that release of
the full and final payment within closely to 30 days after the delivery so
you must have noticed you know the payment terms in the above case a bit
complex now let’s take another example letting us take an example of small n
company which is involved in the business of supplying leather
necessaries the great policy of the company is that you know the all the
payment is due within let’s say 45 days of the delivery of the goods of
the customers from as opposed to the great in company that were discussed
here small company has very simple payment terms no matter how simple or
complex they create policy or payment terms a company has they are bound to
some credit risk that is involved greater is nothing but the fact that the
customer might not end up paying the amount when it is due so there are two
thoughts about the fact that this would lead to loss to the company so to
account for the loss the company maintains a provision in its books of
accounts which are known as the bad debt reserves account right so why is this
bad debt reserve account is required see accounting has its own rules and
principles right which needs to be other – while maintaining and updating the
books of accounts the basic governing accounting principle that is the
conservatism principle of accounting which indicates that you know any losses
that should be accounted for it the earliest while the profit should be
accounted for only after these sufficient proof
or of that particular thing is available or is available that the profit will be
accrued in the near future so since there is always a possibility of debt
debt turning into bad and the customers not paying the complete amount we tend
to maintain or reserve in the books of accounts for the future event which we
called as he bad debt reserve now you must have got a clearer idea regarding
bad debt reserve now let’s take an example so as to understand this in a
more detailed and crystal-clear format so to understand how bad debt reserve
works let’s understand let’s first see the basic entry which we pass for the
accounting or credit sale transaction in the books of accounts let’s say
there’s a company called kg Inc which has received in order for let’s say for
500 leather wallets leather wallets is what they have got the order
for now the selling price for the product is let’s say 10$
each and it has successfully delivered this goods at the customer’s warehouse
as for the pre-approval terms of trade so the risk of the inventory has passed
on to the customer when the customers accepted the delivery of the goods and
at this point of time will pass in journal entry something like this the
account receivable account that will be debited which will be closely to 5000 to the sales account that will be 5000 so as we can see that
you know the account receivable will always show a debit balance in the books
of whereas you know the sales being the revenue will be transferred to the
profit and loss account right so in that scenario what we can do that you know
now as for the purpose of the bad debt reserve is to offset the account receivables
it hat it has a credit balance right and the entry for the same will go something
like this like you know the bad debt account or the bad debt expense
account will be debited that will be 50 and too bad debt reserve
which will have a credit entry to the extent of 50 so the bad debt reserve
account will reduce the account receivable over here by $50 in the net
account receivable to be presented in the books of accounts will be at 4950
5000 less 50 right in the balance sheet of the
companies in the in the company now let’s understand the bad debt reserve
accounting see as you must have noticed you know there are two different
accounts that have been used for giving for to give the debit effect for the
above bad debt reserve journal entry this because you know there are there are two
ways to account for bad debt expense one is the direct bad debt written off method
now this particular method is used when the organisation can pinpoint invoice
for which the payment is not going to be received so this method invokes or you
can say that this method involves writing of the revenues itself and it’s
possible when there is one-to-one correlation this is very important point
for this particular method a one-to-one correlation between them
between the sales and the debt turning bad so this is an aggressive method
quite aggressive one and and in the case the entire invoices reverse which also
leads to the reversal of the taxes and the other statutory dues booked along
the invoice a second which is known as the provision method now this is the
less aggressive method to account for the bad debt reserve in this case you know a provision is created for the bad debt expenses which can be written off in the
next accounting period and again a fresh provision is created so most
organizations prefer to go ahead with the with this particular method and this
method goes hand-in-hand with the matching concept you can say matching
concept and the accrual accounting of system okay matching concept is
basically the revenue that has been booked in the
given period of time and should be matched with the expenses incurred
towards earning that revenue which basically means that the expenses should
also be recognized in the same period in which the revenue has been recognized so
by using the provision method you can recognize the bad debt allowance in
the period in which the revenue is booked now
the above advantage of the provision method is the disadvantage of the direct
bad debt written-off method so there will be always be a time lag between or
time lag when the revenue is booked and the company is sure that the amount will
not be receivable so this does not go well with the matching concept with the
accounting and so it’s therefore not accepted by the accounting standard as
well so or there are a couple of methods that you can know they’re techniques to
estimate the bad debt allowances the first method is by you know you can go for the
historical method the second method that people takes into account is the Pareto
analysis a very fantastic way of analyzing things in any business okay so
this were the two methods that can be used in the course and there are a
couple of things that you know bad debt reserve are used to basically manipulate
the books of accounts see bad debt reserve are like you know here’s a good
technique which can be used to decrease the net taxable profit of the company
which will help actually to reduce the tax expense and therefore you know there
is a strict rules which will prevent the companies to take benefit of the
bad debt reserve for tax saving purpose this is it for the bad debt reserve if you
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