The term "Bad Debt" is used to describe the situation when a business is unable to obtain payment for an amount of money that is legally and properly owed to it.
For example, a business sells goods to a customer. There is nothing wrong with the goods and the customer keeps them and uses them. However, when the time comes for the customer to pay the bill, they do not pay the debt or they cannot pay the debt. This may occur because the customer has no money and becomes bankrupt, or they simply disappear.
Usually, when a customer does not pay their bill, the business will put pressure on the customer to pay. This pressure may include:
However, depending on the relative size of the debt, the business may choose to give up chasing the debt because to continue the chase takes up more time and money.
When the business decides to give up on the debt, it must "write off" the debt. This "write off" is put into action by writing and posting a journal to the general ledger that:
The particular asset account that is reduced is called "Accounts Receivable" (also known as Debtors). This is a Current Asset and it appears on the Balance Sheet. Assets appear on the debit side and therefore to reduce the asset the journal must credit Accounts Receivable.
Here's an example Accounts Receivable account:
|01-02-12 Opening Balance||24,695.00|
|28-02-12 Sales on Credit||140,121.00||164,816.00|
|28-02-12 Bad Debts||2,137.00||4,215.00|
In the above example, the business asset "Accounts Receivable" was $24,695 at the start of the month of February. In the month of February it sold $140,121 of goods on credit but received payments from its customers of $158,464.00. Normally, the Accounts Receivable figure would have been $6,352 at the end of the month. However the business chose to write off a debt of $2,137 that was nearly one year old. This amount was credited to the Accounts Receivable account thus reducing the final balance for the month to $4,215.
Of course, the double entry bookkeeping principle requires an entry somewhere else in the accounts that "balances" the credit of $2137. Therefore this balancing entry must be a debit.
So what account should be debited?
Well, it's an account called "Bad Debts". This is an expense account. The account will look something like this.
|01-02-12 Opening Balance||3,209.00|
|28-02-12 Accounts Receivable||2,137.00||5,346.00|
In the above example, the business already has $3,209 of bad debts written off at the start of the month, and during the month it wrote off another $2,137. Therefore at the end of the month, the total of Bad Debts had increased to $5,346.00
It should always be remembered that it is a very important accounting principle that assets must be correctly valued. In the above example, if a business knows that there is very little or no chance that the sum of $2137 will be paid, then there is a duty to re-adjust the value of the Accounts Receivable Asset.
If you are wondering why Accounts Receivable is an asset, then you should realise that in normal circumstances Accounts Receivable represents an amount of money that is likely to paid in the very near future. It will eventually find its way to the businesses bank account. So as customers pay off their debts, the asset "Accounts Receivable" converts into the asset "Cash at Bank".