Bad Debt and Doubtful Accounts - Explained
What are bad debts, doubtful accounts, writeoffs, and reserves?
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Table of ContentsWhat is a Bad Debt?What are Doubtful Accounts?What is a Bad Debt Reserve?What is a Write-Off?How to Account for Bad Debts
What is a Bad Debt?
A bad debt refers to an account receivable that has been specifically identified as uncollectible and, therefore, it is written off. Bad debt occurs when a borrower or debtor defaults - fails to repay his or her loan or debt.
Such accounts are removed from the accounts receivable. You then match it against the original invoice. By doing this, you remove both the credit memo as well as the invoice from the accounts receivable statement report.
What are Doubtful Accounts?
A doubtful debt refers to an account receivable that is likely to become a uncollectible in the future. It is difficult to point out which specific customer is likely to default. For this reason, banks usually create what we call a reserve account (also known as a bad debt reserve or allowance for doubtful accounts) for accounts receivable that is likely to become bad debts.
The allowance for doubtful debts accounts shows the loans current balance that the bank expects to default, so there is adjustment done to the balance sheet to reflect that particular balance.
What is a Bad Debt Reserve?
A bad debt reserve, also known as an Allowance for Doubtful Accounts, is an estimate of a company's accounts receivable that can no longer be collected due to defaults.
Creating a bad debt reserve reduces the accounts receivable on a company's balance sheet.
The Allowance for Doubtful Accounts is a Contra account. A contra account is an asset account that is used to offset a parent account - in this case, the accounts receivable.
My allowance is going to be a negative number because it offsets. Taking the Account Receivable and contra account together is going to give you my net realizable value, the total cash value.
The the amount that a company keeps as bad debt reserve is determined by the company's management and the nature of the industry.
A percentage of sales or historical average can also be used to estimate a bad debt expense in a company.
What is a Write-Off?
A write-off refers to a term in accounting where a business reduces the value of its assets because it is uncollectible (a bad debt), resulting in a loss.
So, to account for it, businesses usually write it off to be able to balance their accounts.
Businesses make use of a write-off to account for the following:
- Unpaid check loans obligation
- Unpaid receivables
- Lost inventory
How to Account for Bad Debts
Using the double-entry accounting method, a business records the amount of money the customers owe it in an Account Receivable Account.
The business will also create a bad debt reserve - also known as an allowance for doubtful accounts - to reflect the estimation for uncollectible or bad debts.
The Generally Accepted Accounting Principles (GAAP) details the accounting entries for a write-off. The most common methods in business accounting for write-offs include: Allowance Method and the Direct Write-Off Method.
The entries to be used differ depending on each individual case.