An entity which may not be able to recover its outstanding balance in respect of certain receivables. In accountancy term we can refer to such receivables as Irrecoverable Debts or Bad Debts. irrecoverable debts could be arise for a number of reasons or matter such as when customer going to bankrupt or trade dispute or fraud.
If we think buying something goods, it's easy to picture ourselves to standing at the checkout, writing out a personal check, and taking possession of the goods. It's a simple way of transaction—we exchange our money for the store's business.
Every time an entity realizes that it unlikely to recover its debt from a receivable, it must be 'write off' the bad debt or irrecoverable debts from its receivable books. This ensures that the entity's assets are not stated above the amount it is reasonably expect to recover which is in line with the prudence concept.
Accounting entry required to write off a bad debt or irrecoverable debts is as follows:
Debit Bad Debt Expense
Credit Receivable
The credit entry reduces the receivable balance that were recognized to balance sheet. The debit entry has the effect of cancelling the impact on profit of the sales that were previously recognized in the income statement.
In the world of business today, however,most of the company wants to sell their goods on credit. This would be equivalent to the grocer of transferring their ownership of the business to you, issuing a sales invoice, and allowing you to pay for the business at a later date.
Example
Rahim LTD sells goods to Karim LTD for $800 on credit. Rahim LTD subsequently finds out that Karim LTD is being liquidated and therefore the prospects of recovering its dues are very low.
Rahim LTD should write off the receivable from Karim LTD in view of the circumstances. The double entry will be recorded as follows:
Debit Bad Debt Expense 800
Credit Receivable 800
Whenever a retailer decides to offer its goods or services on credit, two things happen on that time: (1) the retailer boosts its potential to increase revenues since many customers appreciate the convenience and efficiency of making purchases on credit term, and (2) the retailer opens itself up to potential losses if its customers do not pay the sales invoice amount when it becomes due.
Under the accrual basis of accounting a sale on credit will:
Increase sales or revenues, which are reported on the income statement, and
Increase the amount due from customers, which is reported as accounts receivable.
If a customer does not pay the amount it owes, the seller will report:
A credit loss or bad debts or irrecoverable debts expense on its income statement.
With respect to statements of financial position, the seller should be report its estimated credit losses as soon as possible using the receivable allowance method. For income tax purposes, however, losses shoud be reported at a later date through the use of the direct write-off method.
Recording Services Provided on Credit
Assume that on may 8, hunny Design Co. provides $5,000 of graphic design service to one of its customer with credit terms of net 30 days time.
Under the accrual basis of accounting concept, revenues and sales are considered earned at the time when the services are provided. This means that on may 8 hunny will record the revenues it earned, even though hunny will not receive the $5,000 until may. Below are the accounts affected on mat 8, the day the service transaction was completed:
In this transaction, the debit to Accounts Receivable increases hunny's current assets, total assets, working capital, and stockholders' equity—all of which are reported on its financial statement. The credit to Service Revenues will be increased Malloy's revenues and net income—both of which are reported on its income statement.
Accounts receivable are not always be collected in full due to many reasons. Sometimes buyer simply evade payment and the cost of pursuing them is more than the recoverable amount and sometimes they become go to bankrupt, sometimes the debt becomes time-barred etc. A debt which is determined to be uncollectible i.e. there is no chance that the debt would be collected, is called a bad debt or irrecoverable debts. Bad debts or irrecoverable debts were written off from accounts as soon as they are determined. This is because a organisation does not expect future economic benefits from a bad debt and it no longer remains an asset
