When a business decides to write off an account payable owed it as bad debt, it creates a bad debt expense. This is the accountant's method for adjusting accounts in the interest of accounting accuracy.
The bad debt expense enters the accounting system with two simultaneous transactions.
- Firstly, the firm debits a non-cash expense account, Bad debt expense. This expense along with other expenses will be subtracted from sales revenues on the Income statement, thereby lowering Net income (Net profit).
- Secondly, the firm credits a contra asset account, Allowance for doubtful accounts for the same amount. On the Balance sheet, an Allowance for doubtful accounts balance lowers the firm's Net accounts receivable. As a result, the action also lowers the value of Current assets and Total assets.
The examples below further explain how a company writes off bad debt and how these accounts impact each other. The discussion also examines the impact of writing off bad debts on the Income statement, Balance sheet, and statement of changes in financial position.
Explaining Allowance For Doubtful Accounts in Context
Sections below further define, explain, and illustrate allowance for doubtful accounts. Note especially that the term appears in context with related terms and concepts, including the following:
- What is allowance for doubtful accounts?
- Allowance for doubtful accounts for bad debt. Writing off bad debt.
- Balance sheet example of bad debt write off.
- What is the impact of allowance for doubtful accounts on financial statements?
Before there can be a Bad debt expense or Allowance for doubtful accounts, there must be an Account receivable. This is an account owed to an entity, usually by one of its customers as a result of a recent sale or the ordinary extension of credit. A firm that sells and ships goods to a customer, along with an invoice, has an Account receivable until the customer actually pays.
The invoice will state payment terms such as "Net 30," or "Net 60," which means the customer is obligated to pay the balance due no more than 30 or 60 days after receiving the invoice. Payment is overdue if the customer does not pay by the due date.
When Customer Payment is Overdue
When customer payment becomes overdue on an Account receivable, sellers usually notify the customer of the overdue status, and then watch the overdue account for another 30 days, 60 days, or some other time period. During this time the seller continues trying to collect payment.
If payment is still not forthcoming during that period, the seller will choose one of two possible actions:
- Firstly, continue trying to collect payment.
This may include intensified collection efforts, such as using a Collection service or a law suit against the non paying customer. These options, however, can raise the cost of collection substantially.
- Secondly, recognize the debt as a bad debt expense and write off the debt.
Creditors take this action in the interest of accounting accuracy. A write-off adjusts the sellers Net accounts receivable to reflect the reality. Sellers choose this option when they believe the customer will never pay. This might occur, for instance, when the customer goes out of business or declares bankruptcy.
Transactions in Writing Off Debt
The term, as it appears in this article, is an accounting term. As far as the accounting system is concerned, a write off begins with transactions in two accounts:
- Firstly, Bad debt expense, a non cash expense account.
- Secondly, Allowance for doubtful accounts, a contra asset account.
Exhibit 1 below shows how these appear in the journal.
Journal for Fiscal Year 20YY
| 630 Bad debt expense|
120 Allowance for doubtful accounts
Exhibit 1. Journal entries to start the write-off process.
Double entry bookkeeping requires at two transactions for the write off action: one a debit and the other an equal, offsetting credit. Here, the account Bad debt expense is a normal expense category account whose balance increases with a debit transaction. The other account, Allowance for doubtful accounts, is an asset category account, but it is also a contra asset account. Therefore, this account's value increases with a credit (the reverse of the impact a credit has on a normal asset account.
Writing off the debt this way, incidentally, does not relieve the debtor of the obligation to pay. The seller undertakes the write off in the interest of accounting accuracy, but the customer is still liable for the debt. The seller retains every right to pursue payment by other legal means, such as engaging a collection service or filing a law suit.
Sometimes, customers do ultimately pay the debt, but after the creditor makes the write off transactions. In that case, If the payment comes before the end of the reporting period, the impacts of the initial write transactions can be reversed.
At the end of an accounting period, when financial accounting reports are prepared and published, the sum of receivable accounts appears on the Balance Sheet as Accounts receivable. However, the account Allowance for doubtful accounts also appears along with Accounts receivable to adjust its value downwards, as shown in Exhibit 2 below.
|Grande Corporation Figures in $1,000's
Balance Sheet at 31 December 20YY
Short term investments
Less allowance doubtful accts
Net accounts receivable
Notes receivable short term
Work in progress
Operating & office supplies
Prepaid exp, insurance, def taxes
Total Current Assets
|Long Term Investments and Funds
Common stock held
Preferred stock held
Bonds Held / Sinking funds
Other Long Term Investments
Total Long Term Investments
|Property, Plant & Equipment
Factory Manufacturing Equipment
Less accumulated depreciation
Net factory mfr equipment
Store Equip / Selling Assets
Less accumulated depreciation
Net store/selling equipment
Less accumulated depreciation
Net computer systems
Total Property, Plant & Equip
Trademarks and Patents
Total Intangible Assets
Notes payable, short term
Current portion of long term debt
Accrued expenses, Interest payable
Taxes payable Other withholding
Total Current Liabilities
|Long Term Liabilities
Bank notes payable
Bonds payable, other LT liabilities
Total Long Term Liabilities
Contributed capital excess of par
Total Contributed Capital
Total Owners Equity
| Total Liabilities and Equities
Exhibit 2. Doubtful accounts appear on the Asset "side" of the Balance sheet under Current assets.
See the encyclopedia entry Balance sheet for a more detailed version of the above sheet. For working examples of interrelated financial statements and a full coverage of financial statement metrics, see Financial Metrics Pro.
Writing off debt in this way directly impacts two accounting system accounts: Bad debt expense, Allowance for doubtful accounts. Changes in these accounts, in turn, impact other accounts and the firm's accounting statements as follows:
Income Statement Impact
Under accrual accounting, the company claims sales earned during the period, including those that are still "payable." Accounts receivable itself is not an Income statement line item, but the receivable balance is part of the Income statement item Total net sales Revenues.
The Income statement may also include a line item for Bad debt expense. This normally appears under Operating expenses, below the Gross profit line. As a result, Bad debt expense from a write off lowers bottom line Net income.
Balance Sheet Impact.
On the Balance sheet (Exhibit 2), a write off adds to the balance of Allowance for doubtful accounts. And this, in turn, is subtracted from the Balance sheet asset category Accounts receivable. The result is presented as Net Accounts receivable. The write off, in other words means that Net Accounts receivable is lower than Accounts receivable.
Statement of Changes in Financial Position (Cash Flow Statement)
On the statement of changes in financial position, Bad debt expense appears as a non cash expense item. Bad debt expense from a write off is subtracted from sales revenues, lowering total "Sources of Cash."
Statement of Retained Earnings
Net income (Net profit) from the Income statement makes its way onto the Statement of retained earnings either in the form of dividends paid to share holders, or as retained earnings, or both. Because write off impacts Net income, therefore, the action also lowers dividends and retained earnings on the Statement of retained earnings.