ACCOUNTING FOR BAD DEBTS

Introduction

A firm may sell goods and services to several customers on different terms. When the majority of sale
is on cash basis (advance payment or payment against delivery) then the amount of receivables would
be very less. In this case, a firm may not maintain provision for bad debts and may account actual bad
debt when and if occurs.

However, when a firm sells goods or services to several customers on credit terms, it is likely that few
customers may default and a portion of receivables may not be realised/collected. The amount which
is not collected from a customer is bad debt and needs to be accounted for in the year in which the
firm would have accounted such amounts as sales in conformity with the Realisation and Matching
Concepts. In other words, a firm needs to maintain the provision for bad debts.

Case 1: A firm does not maintain provision for bad debts as bad debt is rare.

Assume a sale of Rs. 1000 to a customer X

Duality at the time of sale (A+E = L+OE+R):

Receivables(X) =1000, Sales = 1000

When the customer defaults and there is sufficient evidence that the outstanding amount will not be
received (the firm would have made significant efforts including legal action to recover the amount),
then the firm has lost this amount and has to be written off as bad debt.

Duality to record the bad debt: Bad debt expenses =1000, Receivables(X) = -1000.

Impact: With reference to customer X, the income statement reflects sales and bad debt expense and
the balance sheet has no receivable. In reality, the firm incurred cost of sales for this sale and did not
recover this amount.

Case 2: A firm maintains provision for bad debts

In the year t, the firm sells goods/services and books the sales, collects money from the customers as
per the credit terms, and ends up with receivables at the end of the year. Out of this amount of
receivables across several customers, it does not know who would default when and what would be
the amount of default at the time of preparation of the closing balance sheet.

However, the firm has some idea as to what proportion of the receivables amount is not collected
every year (past experience, age-wise analysis of outstanding invoices and the reasons for delay in
receipt, etc.)

Assume that a firm does not collect 5% of closing balance of receivables. Further assume that the
closing balance of receivables on 31st December 2011 was Rs. 200,000. At 5%, the firm expects bad
debt expense of Rs. 10,000. One part of duality would be: bad debt expense = 10,000. The entry of
bad debt expense (Rs. 10,000) in the Income Statement neutralises the Sales by the same amount.

(Note: In case 1, bad debt expense of 1000 was actually a loss whereas in case 2, bad debt expense
of 10,000 is not yet lost).

What is the other part of duality? Logically, receivables should be reduced by Rs.10,000 as this
amount is not expected to be collected. However, receivables are still to be shown at Rs. 200,000
because the firm still does not know which customer(s) would not pay and when they would not pay.
What is the way out?

We create a Contra Asset Account contra to receivables named as Provision for Bad Debt and
show Rs. 10,000 in this account. Since it is a contra asset account (asset being receivables), it would
be on the right hand side of the Duality Equation. Finally, the duality:

Bad debt expense = 10,000, Provision for bad debt = 10,000.

Note: Provision for bad debt is on RHS of duality equation but is NOT a LIABILITY. It only
means that it is a Contra Asset Account.

The presentation in the balance sheet is as under (Asset with + sign, Contra Asset with - sign):

Receivables Rs. 200,000

Less: Provision for bad debt 10,000 190,000.

The reader now knows that out of total amount of receivables, a portion is likely to be bad debt and
hence the expected amount of receivable is net amount. The reader also knows that such an amount
has been reflected in the income statement and the profit for the year is understated by this amount.

Note: Normally, the above entry for the provision is made on the last day of the financial year.

Future Period(s)

Having made provision for the bad debt, the actual bad debt in future period can be any amount i.e.
greater or less than or equal to the provision amount.

Situation 1: Actual bad debt is less than or equal to the provision amount i.e. less than or equal to Rs.
10,000

Assume that the actual bad debt during the period t+1 was Rs. 8,000. At this stage the firm knows that
which customer (say, Y) had not paid/defaulted.

Duality: Receivables(Y) = -8000 and Provision for bad debt= -8000.

Now, the provision account has a balance of Rs. 2,000. Assume that at the end of the year t+1, the
closing balance of receivables is Rs. 260,000 and the firm wishes to make provision @ 5%. The
balance required in the provision account would be Rs. 13,000 (5% of Rs. 260,000), the available
balance is Rs. 2,000 and hence, the incremental provision amount at the end of t+1 would be Rs.
11,000.

Duality: Bad debt expenses=Rs. 11,000 and Provision for the bad debt = Rs. 11,000.

The presentation in the balance sheet is as under:

Receivables Rs. 260,000

Less: Provision for bad debt 13,000 247,000.

Situation 2: Actual bad debt is more than the provision amount i.e. more than Rs. 10,000

Assume that the actual bad debt during the period t+1 was Rs. 12,000. This is a case of estimation
error/under provisioning in the previous year.

When actual bad debt amount is accounted then:

Duality: Receivables(Y)= -12000 and Provision for bad debt= -12,000. This entry is made as and
when the bad debt occurs. After this entry, the balance in the provision account is -2,000 (indicates
shortfall in provision in the previous year).

Assume that at the end of the year t+1, the closing balance of receivables is Rs. 260,000 and the firm
wishes to make provision @ 5%. The balance required in the provision account would be Rs. 13,000
(5% of Rs. 260,000), the available balance is -2,000 and hence, the incremental provision amount at
the end of t+1 would be Rs. 15,000.

Duality: Bad debt expenses=Rs. 15,000 and Provision for the bad debt = Rs. 15,000. Thus, the income
statement of the year t+1 would have total bad debt expense of Rs. 15,000 and the closing balance in
the provision account would be Rs. 13,000 (equal to 5% of receivables =260,000).

The presentation in the balance sheet is as under:

Receivables Rs. 260,000

Less: Provision for bad debt 13,000 247,000.

The above cycle continues as long as required.

Accounting for recovery of bad debt written off

There are surprises!!! A firm writes off the outstanding amount from a customer at some point of time
and recovers the same at a future date! This needs to be accounted for and the accounting treatment
would be different for 2 cases described above.

Case 1: If the firm does not maintain provision for bad debts and writes off actual bad debt as when it
occurs (Case 1 described above) then such recovery of bad debt written off is the income for the firm
(because such bad debt was treated as expense earlier).

Consider the example of Case 1. Assume that the customer X repays Rs. 1000 at a future date. The
duality would be:

Cash/bank =1000 and Other income-recovery of bad debt=1000 (however, this income pertains to
prior period (the year in which it was written off as bad debt) and not to the year in which it is
received).

Case 2: If the firm maintains the provision for the bad debts then recovery of bad debt written off is
routed through the provision account i.e. added to this account (logic because the bad debt was
written off against the balance in the provision account).

Consider the example of Situation 1 of Case 2. Assume that the customer Y repays Rs. 8,000 at a
future date.

Cash/bank =8,000 and Provision for bad debt=8,000.

Note: Such recovery would reduce incremental provision amount at the year end and hence,
such recovery would have positive impact on the profit of the year in which recovery takes
place.

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