Accounting for Written Off Bad Debts: Definition, Example, and Journal Entries

Accounts receivable is an account in the balance sheet that represents the amount customers owe to a company. This account holds all the receivable balances which may come from various customers.

For most companies, this account also represents the total credit sales made by a customer with pending payments. Any company that offers a credit term for sales will also accumulate a balance in the accounts receivable account.

The accounts receivable account in the balance sheet increases when companies make a credit sale. In contrast, it reduces when customers repay their balances.

However, this balance also decreases when customers cannot repay their balance. These instances are common for companies that provide credit terms to customers for their sales.

It is crucial to understand these reductions and how to account for them.

What is a Bad Debt?

When companies provide credit sales, they accumulate the amount in the accounts receivable account. Subsequently, when the customer repays their owed amount, the company reduces that account balance.

However, some customers may also fail to reimburse the company. It may happen for several reasons, for example, the customer going through liquidation or bankruptcy.

When customers fail to repay their owed amount to the company, it fails in bad debt. This bad debt is an expense in the income statement representing a receivable that is not collectible.

For the company, it results in a bad debt expense in the income statement. Similarly, it reduces the accounts receivable balance reported in the balance sheet.

Bad debts are typical for companies that extend credit to their customers. Usually, most companies expect a specific percentage of customers not to repay their debts. This expectation stems from historical dealings with customers.

For any accounts receivable balance that a company deems irrecoverable, it must write off the owed amount.

Companies sometimes also estimate a debt provision that may be doubtful. However, doubtful debts are not the same as bad debts.

Instead, they are estimates based on a percentage companies use to calculate those doubtful debts.

This process may still create an expense in the income statement for companies. However, these are not similar to written-off bad debts.

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Overall, bad debts are receivable balances that a company deems irrecoverable. When companies extend credit sales to customers, they expect some customers not to repay them. Usually, customers may have a valid reason to do so.

Even if they don’t, companies are unlikely to pursue most bad debts due to the time and expenses required. Either way, companies will write off the balance in the income statement as bad debts.

What is the Accounting for Written Off Bad Debts?

The accounting for writing off bad debts depends on the method companies use to record them. In essence, there are two approaches to writing off bad debts.

These include the direct write-off and provision for doubtful debts methods. Both processes differ from each other and how companies calculate bad debts. An explanation of each of these is as below.

Direct write-off method

In the direct write-off method in accounting for bad debts, companies calculate the bad debts for each customer.

This process involves charging bad debts to the income statement only when an invoice becomes irrecoverable.

In most cases, the direct write-off method requires companies to consider each customer and invoice separately. This method results in an accurate amount written off as bad debts.

In the direct write-off method for bad debts, companies record an expense in the income statement.

On the other hand, it also directly reduces the accounts receivable balance. Therefore, it gets the name “direct write-off method.”

Under this method, companies cannot estimate the amounts to write off as bad debts. Instead, it requires an accurate calculation.

Provision for doubtful debt method

Under the provision for doubtful debt method, companies estimate their future bad debts. This estimation results in an expense known as doubtful debts.

Usually, companies use their historical data to establish a percentage to use as a provision for this process.

However, it is not the same as bad debts, which usually come from the direct write-off method. Most companies use both these methods to write off bad debts.

The provision for the doubtful debt method occurs after the direct write-off approach. Once companies identify their bad debts, they will estimate their doubtful debts.

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However, the provision method for doubtful debts does not directly reduce the accounts receivable balance. Instead, it creates a contra-asset account, which reduces that account in the balance sheet.

What are the journal entries for Written Off Bad Debts?

The journal entries for writing off bad debts depend on the method used to account for them. As mentioned above, both processes result in different accounting treatments.

Hence, the journal entries will also vary due to that treatment. Therefore, it is crucial to understand the accounting entries for both methods separately.

Direct write-off method

Under the direct write-off method, companies recognize a bad debt expense in the income statement.

In contrast, they must also directly reduce the accounts receivable balance on the balance sheet.

With this method, companies create a bad debt rather than a doubtful debt. Therefore, the journal entries for writing off bad debts under the direct approach are as follows.

DateParticularsDrCr
 Bad debtsXXXX 
 Accounts receivable XXXX

Provision for doubtful debt method

The journal entries for written-off bad debt under the provision for doubtful debt method are similar. However, they are different.

As mentioned, companies create a doubtful debt expense that goes into the income statement. This expense has the same effect on profits as bad debts. However, the credit side is more complex.

The credit side of the journal entries for written-off bad debt under the provision for doubtful debt creates a provision.

In the first year of accounting for doubtful debts, the total doubtful debt expense also forms the provision account balance.

Companies must compare the calculated doubtful debts with that account balance in subsequent years. Based on the difference, they must create an expense or income.

If the calculated provision for doubtful debts exceeds the existing balance in the account, the journal entries will be as follows.

DateParticularsDrCr
 Doubtful debtsX,XXX 
 Provision for doubtful debts X,XXX

However, if the calculated provision is lower, the journal entries will include the following.

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DateParticularsDrCr
 Provision for doubtful debtsX,XXX 
 Doubtful debts X,XXX

If these debts convert into bad debts, the company must use the following journal entries to record the bad debt.

DateParticularsDrCr
 Provision for doubtful debtsXXXX 
 Accounts receivable XXXX

Example

A company, ABC Co., extends credit to its customers. The company has a total accounts receivable balance of $110,000 at the year-end, including several customer balances.

Of these balances, ABC Co. believes $10,000 to be irrecoverable. Therefore, it records it as written off bad debts as follows.

DateParticularsDrCr
 Bad debts$10,000 
 Accounts receivable $10,000

Similarly, ABC Co. expects 12% of the remaining balance to be doubtful. As per this percentage, the estimated provision for bad debts is $12,000 ([$110,000 – $10,000] x 10%).

However, ABC Co. already has $7,000 in the provision for doubtful debt accounts from the previous year. Therefore, the journal entries for the increased provision will be as below.

DateParticularsDrCr
 Doubtful debts ($12,000 – $7,000)$5,000 
 Provision for doubtful debts $5,000

Is Written Off Bad Debts Expenses or Cost of Goods Sold?

A written-off bad debt is an expense, as opposed to the cost of goods sold. In other words, a written-off bad debt is a non-recoverable amount owed by a customer that is removed from the company’s financial statements as an expense.

In contrast, cost of goods sold (COGS) is the direct costs associated with producing or purchasing a product that is expensed on the income statement when the product is sold.

How is the Written Off Bed Debt Affect the Statement of Cash Flow?

Written Off Bed Debt does not directly affect the statement of cash flow. In the cash flow statement, under the indirect method, it is stated from profit or losses before tax, which is already taking into account written-off expenses.

How is the Written Off Bed Debt Affect the Statement of Change in Equity?

Written-off bad debt is not directly affected the statement of change in equity directly. However, a statement of change in equity, taking into account net profit or losses during the year, is taken from the income statement.

Conclusion

Bad debts are an expense in the income statement representing irrecoverable customer balances.

The accounting for writing off bad debts depends on the method used by companies. In most circumstances, companies use both the direct write-off and provision for doubtful debt methods. However, the journal entries for these methods differ from each other.