How to Get Out of Debt

Accounting for Bad Debts: Estimations & Implications

Conducting business on credit is commonplace; most companies provide services or deliver goods without immediately requiring their clients/customers to pay in full. Instead, they typically expect payment within a set period of time. However, a number of customers/clients inevitably send payment late or do not pay at all.

While default on payments is expected and not collecting debts is objectively not a desirable occurrence, according to some, these defaults are a welcome. Accounting Principles by  Weygandt, Kieso, and Kell, contends,“… from a management point of view, a reasonable amount of uncollectible accounts is evidence of a sound credit policy. When bad debts are abnormally low, there is reason to suspect that the company is losing profitable business by following a credit policy that is too strict.”

Accounting for bad Debt requires various entries on a company’s balance sheet and income statement. The accrual method of accounting requires companies to record a credit sale as follows: the A/R account receivable is debited, and revenue account is credited to recognize a transaction even if money does not change hands immediately, as is the case with credit purchases. A company using the cash method does not have an A/R account on its balance sheet.

The two methods for bad debts are the direct write-off and the allowance method.  The direct write-off method violates the matching principle, because bad debts are not recorded until a company is certain it will not receive payment. This determination could happen during a different accounting period than the transaction, and therefore does not work for the accrual method. However, this method is to be used for tax purposes, as the IRS is only concerned with actual numbers, and would not accept estimation as is seen in the allowance method. The Allowance method involves the use of an allowance for bad debts account; it requires estimates of uncollectibles before these accounts actually are realized as bad debts. One specific task of a accountant  is to predict uncollectibles for financial reporting purposes.

Gaining an understanding of terms and concepts that are used in this process is essential to maintaining compliance under GAAP as well as effectively operating a business.

Key Terms& Concepts:

The Accounts Receivable balance is an asset account representing the money due from customers. When sales are made on credit, the amount due to the company is debited to this account to signify the pending payments. The corresponding entry credits the revenues account on the income statement by the same amount.

The next concept to be familiar with is the Allowance for bad debts. A typical company estimates the amount it has in bad debts in a given period. These estimates are then debited to the bad debts expense on the income sheet and credited to the allowance for bad debts account. Next, a company will receive a number of payments, but for those payments not received, the company will have to determine if these accounts will be deemed “bad debt” and be “uncollectible.” An account is deemed “uncollectible” when every effort to collect The Debt is made. It is also indicated by a person’s bankruptcy filing. The allowance for bad debts account is a contra account. An account can be considered a contra account when it has a credit balance that is subtracted from a related asset on the balance sheet.  The mechanics of a contra asset account are the opposite of an asset account (i.e. it increases with credit entries and decreases with debit entries). When debts are written off, the accounts receivable account is credited and the allowance for doubtful accounts is debited. The net realizable value of accounts receivable (A/R less Allowance for bad debts) does not change. In the direct write-off method, there is no allowance for doubtful debt, and accountants make no estimation about future uncollectibles.

Literature on this topic explains he mechanics in detail, but only glosses over the actual estimation process. In the article Corporate Earnings: Facts and Fiction,  Professor Baruch Lev, explains the ambiguous nature of finding ‘truths’ in financial statements.  He states, “…to people…engaged in business and finance, a true statement is simple one that corresponds to reality, or facts. Thus, GE’s statement made on… its balance sheet… is true, if confirmed by bank and custodian’s statements…. But is GE’s statement… true?” This company uses the data on its income statement, included is the figure for expected losses on financing receivables, but that expense “reflects management’s best estimate of probable losses based on historical experience.” Professor Lev puts it quite bluntly, “This is not fact.” Given the role estimate plays in accounting for accounts receivable, important issues arise. Whether fraudulent or simply misguided, estimations that do not give a an accurate measure in retrospect can be detrimental to the economy. Even if the estimates are based on historical figures, it’s arguable that the current financial situation has been anything about typical, and therefore, an estimation on historical data is not appropriate anymore.

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Martin Lewis, Good Debt, Bad Debt

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