How to write off a bad debt
/What is a Bad Debt?
A bad debt is a receivable that a customer will not pay. Bad debts are possible whenever credit is extended to customers. They arise when a company extends too much credit to a customer that is incapable of paying back the debt, resulting in either a delayed, reduced, or missing payment.
How to Write Off a Bad Debt
A bad debt can be written off using either the direct write off method or the provision method. The first approach tends to delay recognition of the bad debt expense. It is necessary to write off a bad debt when the related customer invoice is considered to be uncollectible. Otherwise, a business will carry an inordinately high accounts receivable balance that overstates the amount of outstanding customer invoices that will eventually be converted into cash. There are two ways to account for a bad debt, which are noted below:
Direct write-off method. Under the direct write-off method, the seller can charge the amount of an invoice to the bad debt expense account when it is certain that the invoice will not be paid. The journal entry is a debit to the bad debt expense account and a credit to the accounts receivable account. It may also be necessary to reverse any related sales tax that was charged on the original invoice, which requires a debit to the sales taxes payable account.
Provision method. Under the provision method, the seller can charge the amount of the invoice to the allowance for doubtful accounts. The journal entry is a debit to the allowance for doubtful accounts and a credit to the accounts receivable account. Again, it may be necessary to debit the sales taxes payable account if sales taxes were charged on the original invoice.
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Comparing the Direct Write-Off Method and the Provision Method
The direct write-off method and the provision method differ in terms of their timing, impact on financial statements, and compliance with generally accepted accounting principles (GAAP). Here is a comparison of the two methods:
Timing of recognition. Under the direct write-off method, bad debts are recorded only when a specific account is deemed uncollectible. There is no expense recognized until the account is actually written off. Conversely, under the provision method, bad debt expense is estimated and recorded in the same period as the revenue it relates to, based on anticipated future uncollectible accounts. This creates a more timely matching of expenses and revenues.
Impact on financial statements. Under the direct write-off method, when an account is written off, bad debt expense increases, and accounts receivable decreases. Conversely, under the provision method, an allowance for doubtful accounts (contra-asset) is established as an estimate of uncollectible accounts, reducing net accounts receivable. This gives a more accurate picture of the expected collectability of accounts receivable.
Compliance with the matching principle. Under the direct write-off method, there is no compliance with the matching principle under GAAP, as expenses are recorded only when specific accounts are identified as uncollectible, which can occur in periods later than when the revenue was recognized. Conversely, the provision method complies with the matching principle, as it estimates and matches the bad debt expense to the period in which the related revenue was earned, improving the alignment of revenues and expenses.
Usage in practice. The direct write-off method is often used by small businesses or for tax purposes, where the matching principle is less of a concern. Conversely, the provision method is widely used by companies that follow GAAP, as it provides a more accurate financial position by recognizing bad debts earlier.