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Short Storyline
Imagine you run a wholesale business and sell goods worth ₹50,000 on credit to a customer. A few months pass, and despite multiple reminders, the customer fails to pay. Now, you realize that the money may never come back.
This unrecoverable amount is called bad debt, and every business faces this issue at some point. But how should you handle it in accounting? 🤔
Let’s break it down step by step!
What is Bad Debt in Accounting?
Bad debt is an amount owed by a customer that is unlikely to be collected. It occurs when a company sells goods or services on credit, but the customer fails to pay, leading to a financial loss.
Real-Life Example
- A company sells ₹1,00,000 worth of electronics to a retailer on credit.
- The retailer goes bankrupt and cannot pay the amount.
- The company writes off ₹1,00,000 as bad debt.
✅ Common in credit-based businesses
✅ Recorded as an expense in the Profit & Loss (P&L) account
✅ Reduces accounts receivable in the Balance Sheet
Key Features of Bad Debt
✅ Occurs when customers fail to pay
✅ Recorded as an expense (loss for the business)
✅ Reduces accounts receivable (assets)
✅ Impacts cash flow and profitability
Types of Bad Debt
| Type | Explanation | Example |
| Specific Write-Off | A confirmed bad debt where the customer has declared bankruptcy or disappeared. | A company writes off ₹10,000 when a customer officially closes down. |
| Allowance for Doubtful Debts | A business estimates potential bad debts before they occur and records them as an expense. | A company expects that 2% of total sales will turn into bad debts. |
Bad Debt vs. Doubtful Debt
| Feature | Bad Debt | Doubtful Debt |
| Definition | A debt that is confirmed to be uncollectible | A debt that might become uncollectible |
| Accounting Treatment | Written off as an expense | An allowance is created as a precaution |
| Example | A company closes down, and you can’t recover the amount | A customer delays payment beyond the due date |
What is the Journal Entry for Bad Debt?
Method 1: Direct Write-Off (When Debt Becomes Uncollectible)
A company sells ₹10,000 on credit, but the customer fails to pay.
Journal Entry (Bad Debt Written Off)
Debit: Bad Debt Expense ₹10,000 (Recognizing loss)
Credit: Accounts Receivable ₹10,000 (Removing the unpaid amount)
Narration: “Recorded ₹10,000 as bad debt expense due to customer non-payment.”
Method 2: Allowance for Doubtful Debts (Estimating Bad Debts in Advance)
If a business expects ₹20,000 in unpaid invoices, it records an allowance instead of waiting for debts to go bad.
Journal Entry (Creating Provision for Bad Debts)
Debit: Bad Debt Expense ₹20,000
Credit: Allowance for Doubtful Debts ₹20,000
Narration: “Recorded ₹20,000 as an allowance for doubtful debts.”
If a specific customer fails to pay later, the company uses this allowance instead of affecting the P&L again.
Journal Entry (Using Allowance to Write Off Debt)
Debit: Allowance for Doubtful Debts ₹5,000
Credit: Accounts Receivable ₹5,000
Real-Life Example
A company sells ₹1,00,000 worth of goods on credit.
- After 6 months, the company realizes that ₹5,000 will never be recovered.
- It writes off ₹5,000 as bad debt.
Accounting Impact:
- Bad debt expense increases in the P&L Statement.
- Accounts receivable decreases in the Balance Sheet.
- Net profit decreases because of the additional expense.
Where Does Bad Debt Appear in Financial Statements?
Balance Sheet (After Bad Debt Write-Off)
Bad debt reduces accounts receivable, affecting current assets.
Balance Sheet
————————————–
Credit (Cr) | Debit (Dr)
————————————–
Liabilities | Assets
– Accounts Payable ₹50,000 | – Accounts Receivable ₹95,000
| (₹1,00,000 – ₹5,000 bad debt)
————————————–
Profit & Loss Statement (Bad Debt as an Expense)
Bad debt appears under Operating Expenses, reducing profit.
Profit & Loss Statement
————————————–
Credit (Cr) | Debit (Dr)
————————————–
Revenue | Expenses
– Sales Revenue ₹5,00,000 | – Bad Debt Expense ₹5,000
| – Rent Expense ₹50,000
————————————–
Net Profit: ₹4,45,000
————————————–
How to Calculate Bad Debt Expense?
Formula:
Bad Debt Expense = Total Credit Sales × Expected Bad Debt %
Example Calculation:
- A company’s credit sales = ₹10,00,000
- Expected bad debt = 2%
- Bad Debt Expense = ₹10,00,000 × 2% = ₹20,000
How Does Bad Debt Affect Cash Flow?
❌ Decreases expected cash inflows
❌ Reduces accounts receivable balance
❌ Increases expenses, reducing net profit
How Do Companies Recover Bad Debt?
✅ Legal action – Suing customers in extreme cases
✅ Debt collection agencies – Hiring third-party collectors
✅ Negotiations & settlements – Offering discounts for partial payments
Common Mistakes to Avoid
🚫 Not estimating bad debts – Can lead to sudden financial losses.
🚫 Writing off debts too late – Affects cash flow planning.
🚫 Failing to track customer payment history – Leads to repeated bad debts.
Relevant Accounting Standards (GAAP, IFRS, IAS)
- IFRS 9 – Financial Instruments (Deals with credit losses)
- IAS 37 – Provisions, Contingent Liabilities & Assets
- US GAAP (ASC 326) – Current Expected Credit Losses (CECL) Model
For more details, check GAAP vs. IFRS Differences.
FAQs
1. Is Bad Debt an Expense or a Liability?
✅ Expense – It appears in the Profit & Loss Statement under Operating Expenses.
2. Where Does Bad Debt Appear in Profit & Loss Account?
Under “Bad Debt Expense” in Operating Expenses.
3. Can a Company Recover Bad Debt?
✅ Yes, through legal action, settlements, or collection agencies.
What is the Difference Between Bad Debt and Doubtful Debt?
| Feature | Bad Debt | Doubtful Debt |
| Certainty | Confirmed loss | Uncertain loss (may be paid later) |
| Recorded as | Expense | Allowance/provision |
What Happens If a Written-Off Debt is Recovered?
A reversal entry is made:
Debit: Cash/Bank ₹5,000
Credit: Bad Debt Recovery ₹5,000
Conclusion Bad debts are a reality of business, but proper accounting helps reduce financial impact. Using the Allowance Method and tracking credit sales carefully can protect businesses from major losses.