Back to: Accounting 101
Hi there!
Today, we’re going to discuss something that happens to every business – accounting for bad debts. Let’s find out what they are and how they’re handled in accounting.
Accounting for Bad Debts
A bad debt is money owed to a business that it cannot collect. This can happen when a customer buys goods on credit but doesn’t pay. In accounting, we must account for these bad debts to reflect the true value of our receivables.
What are Bad Debts?
Bad debts are amounts that a business expects it won’t be able to collect. For example, if a shop sells goods on credit to a customer, but the customer can’t pay, that debt is considered bad.
How to Account for Bad Debts:
Direct Write-off Method: The bad debt is removed from the books once it’s determined to be uncollectible.
Allowance Method: A business estimates bad debts and creates an allowance for them in advance, so that when bad debts occur, they’re already accounted for.
Impact of Bad Debts:
Bad debts can negatively affect a business’s cash flow and profitability. It’s important to manage credit sales carefully to minimise bad debts.
Bad debts, also known as doubtful debts, are amounts owed to a business by its customers that are unlikely to be paid. When a business sells goods or services on credit, there is always a risk that the customer may default on payment. To account for bad debts, businesses must estimate the amount of debts that are unlikely to be paid and make a provision for these debts. For example, a company may estimate that 5% of its trade debtors are unlikely to pay, and make a provision of ₦25,000 (5% of ₦500,000 trade debtors).
The provision for bad debts is typically made by debiting the bad debt expense account and crediting the provision for bad debts account. The bad debt expense account is an expense account that represents the cost of uncollectible debts, while the provision for bad debts account is a contra-asset account that reduces the value of the trade debtors account. When a specific debt is deemed uncollectible, the provision for bad debts account is debited and the trade debtors account is credited. For instance, if a customer defaults on a debt of ₦10,000, the provision for bad debts account would be debited by ₦10,000 and the trade debtors account would be credited by ₦10,000.
The accounting treatment for bad debts can vary depending on the specific circumstances. For example, if a business uses the direct write-off method, bad debts are only recognised when they are deemed uncollectible. In contrast, the allowance method involves estimating the amount of bad debts and making a provision for them. The choice of method depends on the business’s accounting policy and the requirements of the relevant accounting standards. In Nigeria, the Financial Reporting Council (FRC) requires businesses to follow the International Financial Reporting Standards (IFRS), which recommend the use of the allowance method.
Conclusion:
Handling bad debts properly ensures that a business’s financial statements are accurate and reflect the true value of its receivables.
Evaluation:
If a business sells N50,000 worth of goods on credit and later realises it cannot collect the amount, how should it record this transaction?
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