Understanding Bad Debts Journal Entry

Understanding Bad Debts Journal Entry

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Jaya
Jaya Sharma
Assistant Manager - Content
Updated on Mar 31, 2024 02:11 IST

Bad debt is an account receivable type for an organization that becomes uncollectible from customers due to the inability of the customer to repay the amount taken on credit.

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In this article, we will be discussing the Bad Debts Journal Entry in detail with examples.

Table of Contents

What is bad debt?

Bad debt is an amount of money that the creditor should write off as a result of a default on the debtor’s part. When the creditor has bad debt on books, it becomes uncollectible and recorded as charge-off. It refers to a contingency that must be accounted for by every business offering credit to customers. 

Such entities estimate how much of the receivables may become uncollectible by using the accounts receivable (AR) aging method or percentage of sales method. Business views bad debts as expenditure since there is less probability of generating revenue from these debts. 

When goods are sold on credit, a situation where some of the customers may fail to pay the amount may arise due to insolvency. Since this amount remains unrecovered, it becomes a bad debt. Whenever the bad debts are recovered, it is known as the bad debts recovered. 

Types of Bad Debts

The following are the types of bad debts:

  1. Auto Loans: It is considered to be bad debts since the value of a vehicle depreciates over important. The car value depreciates due to service history, fuel economy, warranty period, etc. 
  2. Personal Loans: Such loans have a very high rate of interest, due to which it is very easy to fall into the debt trap. If you do not repay the loan on time, then it can pile up before time.
  3. Loan Shark Lenders: These are loan providers that offer loans in the unorganized sector at very high rates. This interest rate is often quite above the legal standard. It makes working with lenders against the law. 
  4. Payday loans: It is one of the worst types of bad debts which are short-term and unsecured loans. The interest rates are extremely high upto as 400%. Due to late fees and multiple services, any miss of the repayment dates can quadruple the debts. 

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Example of Bad Debts Journal Entry

Bad Debts Journal Entry is shown as below. Let us consider the example of Anuj who owes ₹10,000. He has become insolvent due to which this amount has become insolvent. From his property, only 70 paise has been recovered.

Date  Particulars LF Dr. Cr.
  Bad Debts A/c                                  Dr.
To Anuj A/c (Being the due amount from Anuj was irrecoverable)
  10,000/-

10,000/-
  Cash A/c                                           Dr.
Bad Debts A/c                                   Dr.
To Anuj A/c (Being only 70 paise received from amount due from Anuj)
  7,000/-
3,000/-




10,000/-

Let us suppose that out of the bad debts worth ₹ 10,000, ₹ 3000 is the bad debt recovered.

Date  Particulars LF Dr. Cr.
  Cash A/c                                           Dr.
To Bad Debts Recovered A/c
(Being the amount earlier written as bad debts is recovered.) 
  3,000/-

3,000/-

Information about bad debts present outside the trial balance is included before adjustments in final accounts. If these adjustments are not made during the preparation of financial statements, numbers in the firm’s final accounts will be inaccurate. Let us now consider including Bad Debts into Financial Statements.

  • Situation 1: When bad debts are included in trial balance, no adjustment is made. In such cases, P&L is affected.
  • Situation 2: Final accounts are adjusted in case bad debts are given outside trial balance as the supplement information that is called as further bad debts. 
Account Impact
P&L A/c Shown on debit side (add to the bad debts that are already written off)
Balance Sheet Shown on “Asset” side (subtract from the sundry debtors)

Calculation of Bad Debt Expense

There are two ways of calculating the bad debt expense including the Direct Write Off and Allowance Method. 

  1. Direct Write-Off: Here, bad debt is directly written off to a receivable account. While the bad debts account is debited, the accounts receivable account is credited. Although through this method, the exact amount of uncollectible debt is recorded, it does not follow the matching principle of accrual accounting. It is not the most accurate method to theoretically determine bad debts. 
  2. Allowance Method: This method is used when a large amount of money is involved. The organization anticipates that bad debts will occur and prepares accordingly. An allowance for doubtful accounts is created. This is a contra-asset account and reduces loan receivable accounts when both accounts are listed in balance sheet.

Conclusion

When payments from sundry debtors is accepted when their accounts have been written off as bad debts, it is known as the recovery of bad debts. Bad debts journal entry in case of recovery must reflect that it is treated as a gain for business as contrary to bad debts written off. When recording the received money, the debtor should not be credited as in the case of sales.

FAQs

What are the implications of bad debt for a business?

Bad debt can lead to reduced cash flow, lower profits, and a distorted financial picture of the company, potentially affecting its ability to invest, grow, or even meet its own obligations.

How is bad debt accounted for in financial statements?

In financial statements, bad debt is typically recorded as an expense in the income statement, reducing net income. It also affects the accounts receivable balance on the balance sheet.

Can bad debt be written off for tax purposes?

Yes, businesses can often write off bad debt as a deduction on their tax return, reducing their taxable income. However, the specific rules and requirements can vary by jurisdiction.

What is the difference between bad debt and doubtful debt?

Bad debt is deemed uncollectible and written off, while doubtful debt is considered at risk of not being paid but has not yet been written off. Provisions are made for doubtful debts to anticipate potential losses.

How do businesses recover bad debt?

Businesses may attempt to recover bad debt through collection agencies, legal action, or negotiating payment plans with the debtor. However, recovery efforts are not always successful.

About the Author
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Jaya Sharma
Assistant Manager - Content

Jaya is a writer with an experience of over 5 years in content creation and marketing. Her writing style is versatile since she likes to write as per the requirement of the domain. She has worked on Technology, Fina... Read Full Bio