Bad Debt

For any business to thrive successfully it must duly pay attention to all aspects of the business that can likely affect its performance; this includes its credit extension. Businesses are prone to experiencing bad debt when credit extensions are being granted to customers as there is always a tendency that such debts may no longer be covered. Such credits are said to be uncollectible. This is a cross that all businesses that extend credit payments must carry.

What is Bad Debt?

Bad debt can be said to be an outstanding payment or credit that a customer does not pay, thereby, incurring extra expenses on the businesses at a loss. Bad debts usually come about when a business willingly grants a customer a credit extension at risk of not receiving payment at all.

Bad debt can happen under two circumstances;

• When a business overly extends credit payment to a customer that is not capable of repaying the debt. This is as a result of poor managerial skills of the business or any other reasons deemed by the business.

• When a customer misleads a business into granting them sale on credit, whereas, in reality, the customer is incapable of repaying that debt or has no intention of ever repaying the debt. This is as a result of fraud on the part of the customer.

Recording a Bad Debt

Bad debt can be recorded in two ways, which are;

1. Direct write-off method: Here, once accounts have been identified as being uncollectible they are written off. It also records the exact figure for the accounts that have been identified as uncollectible. This method is still less effective as it fails to keep to the matching principle of the generally accepted accounting principles (GAAP) which states that “expenses be matched to related revenues in the same accounting period.”

2. Allowance method: Unlike the direct write-off method, the allowance method is able to match expected bad debts to related revenues even when the receivable and uncollectible accounts are yet to be sorted.

In as much as a business stands the risk of bad debt when once a credit extension is granted, it is not always so. In some cases, customers get to repay debts on time while some repay at a later date (or overdue date). In such a case of overly late debt payment, the initial write-off done on the related receivable can be reversed with the payment being charged against it; rather than creating a new revenue that reflects a late cash payment receipt on an already written-off receivable.

Usually, when recording a bad debt, a debit entry is matched to bad debt expense and an offsetting credit entry is matched to a contra asset account; also known as the allowance for doubtful accounts. This account (allowance for doubtful accounts) nets against the total accounts receivable as presented on the balance sheet, therefore reflecting only the collectible amounts.