What Are the Treatments for Bad Debts in Financial Accounts?
Bad debt represents noncollectable amounts in corporate accounts receivable. A customer usually defaults because of bankruptcy or temporary financial difficulties. An organization generally appraises amounts due from customers, and it calculates the loss, or default, probability by periodically reviewing clients' operating data. An accountant records bad debt as an operating loss.
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Estimating Bad Debt
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A firm's accountant usually partners with a credit officer to estimate amounts that are potentially noncollectable, or nonrecoverable, based on customers' financial information, payment profiles, and updated credit scores and references. (Payment profiles indicate how quick clients pay bills.) U.S. generally accepted accounting principles, or GAAP, and international financial reporting standards, or IFRS, usually require a company to record bad debt expense based on recoverability rates. To illustrate, an accounting manager at a large department store reviews the firm's accounts receivable amounts at the beginning of the year. He notes that 25 percent of customers are more than 120 days past due. The company's total accounts receivable equal $10 million, and the accounting manager wants to record $2.5 million worth of receivables as bad debt. He debits the bad debt expense account for $2.5 million, and he credits the allowance for doubtful items account for the same amount.
Account Write-Off
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The accounting manager at the department store receives a court notice about bankruptcy processes involving all customers in the "25 percent category," and he believes these clients may be unable to pay. He instructs a junior bookkeeper to "write off," or record as a loss, amounts previously recorded as bad debt. The bookkeeper debits the allowance for doubtful items account (to bring its balance back to zero) for $2.5 million, and she credits the customer receivables account for the same amount. Customer receivables, also known as accounts receivable, is an asset account, and a debit to an asset account reduces its balance. The company's balance sheet, or statement of financial position, indicates a current balance of $7.5 million ($10 million minus $2.5 million) for accounts receivable.
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Debt Recovery
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A corporation may recover accounts previously written off provided it is able to collect funds in court. A company can also recover funds if a customer exits a bankruptcy process. To illustrate, three customers in the "25 percent category" reach successful agreements with new lenders, and they are able to resume operations. The department store's credit officer believes all three customers can pay off their balances, currently worth $1.25 million. The accounting manager debits the cash account for $1.25 million, and he credits the customer receivables account for the same amount.
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References
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