The impact of bad debt expense can be detrimental to a business’s financial well-being, as it can significantly reduce profits. A bad debt expense journal entry is an accounting tool used to record any write-offs related to debts that have been deemed uncollectible. It is important for businesses to accurately account for any bad debt expense, as it can have a significant effect on the company’s financial statements. In this blog post, we will explain how to make a bad debt expense journal entry, and why it is important to accurately record bad debt expenses. We will also provide an example of a bad debt expense journal entry to illustrate the process. By the end of this blog post, you should have a better understanding of the journal entry process for bad debt expenses and why it is important for businesses to perform this task correctly.
What are some types of bad debt?
There are multiple types of bad debts to consider, including:
Personal loans
A personal loan is a sum of money that you borrow from a lender to fund a personal project, such as a large purchase, travel, investment, or medical bill. Personal loans have interest rates, too, just like credit cards, and they can change depending on your credit history. These interest rates can vary anywhere between 5% and 35%. Installments for personal loans are typically due each month. Though the majority of repayments can take between two and five years depending on the amount, it’s imperative that someone pay off the loan as soon as possible for this kind of bad debt.
Credit card debt
Customers frequently receive credit cards from lenders so they can make purchases. These cards may have higher interest rates depending on the lender, which means that a customer must pay more the longer it takes to complete the entire transaction. The bad debt is the amount you owe on the credit card, not the card itself. This means that a cardholder must exercise restraint when it comes to spending within their means and repaying any debts on time in order to avoid accruing additional interest or fees.
Auto loans
Customers frequently obtain auto loans when buying a vehicle at a dealership. A person can pay more up front to help reduce the interest rate they incur on the car. The value of a car decreases over time due to a number of factors, including fuel efficiency, warranty duration, and other conditional changes. In order to maximize their return on investment, it is crucial for the owner to decide when to trade or sell their vehicle.
Moneylender deals
This kind of lender can waive the background check and credit report, making it simpler for you to get a loan. Because you typically repay the loan within a short period of time, this type of bad debt has interest rates that accumulate quickly. It’s imperative that you settle this bad debt with a moneylender as soon as you have the resources to do so.
Payday loans
Payday loans are unique bad debts because they are short-term and often come with interest rates that can go up to 400% High interest rates encourage the borrower to pay off the loan quickly in addition to late and service fees. By doing so, you can prevent debt from accruing further and save a sizable sum of money.
Service provider and trader nonpayments
If a customer doesn’t pay after a trader sells a good or a service provider completes a task, a bad debt may be created. In these situations, a company may use collectors’ services to get the money they’re owed. It’s beneficial for their financial statements if they can eliminate a bad debt because it shows a history of timely payment recovery. Investors evaluate a company’s profitability and credibility based on these information.
What is a bad debt?
A bad debt, also known as a doubtful debt, is a category of accounts receivable, which refers to the sum of money that a client owes a business. If the business doubts its ability to obtain payment from the customer, an accounts receivable is a bad debt in this case. They record the lost payment as an expense on their financial records when this occurs. There are a variety of reasons why a business cannot fully recover a debt, including payment disputes, bankruptcies, and customers who simply do not pay.
A business views bad debts as expenses because there is little chance that they will generate future financial benefits. By writing it off, the business can avoid overstating the value of their current assets and save money during tax season. Writing off bad expenses also enables the business to lower the reported balance of its receivables because bad expenses aren’t assets. Lower accounts receivables indicate sound financial condition because they show that the business can successfully collect its payments.
Why is a bad debt expense important?
A bad debt expense is crucial for a number of reasons, such as:
How to use the direct write-off method
You can use the direct write-off method to perform a bad debt expense journal entry by following these three steps:
1. Identify the bad debts
Identifying which of your customer accounts are bad debts is the first step in performing an expense journal entry. Search for patterns and sudden shifts in a customer’s purchasing behavior. A sign of a bad debt is when a previously reliable customer suddenly stops making payments. Sometimes your customers might confess that theyre having financial problems. To find out how long they delayed paying, you could also check their accounts receivable. Utilize this information to help you decide which items to write off.
2. Try to collect before writing them off
Make sure you exhaust all potential avenues for collecting the payments before they have an impact on the company’s financial records before you decide to write off the accounts receivable as bad debts. Employ debt collectors, who are knowledgeable professionals at negotiating and recovering payments from past-due customers, as an example. In order to try to create a payment plan that takes into account the customer’s financial situation, get in touch with the customer to find out their reasons for nonpayment.
3. Record it on your balance sheet
When a debt has been determined to be completely unrecoverable, it is recorded on the balance sheet. Fill out the accounts receivable and allowance for doubtful debts sections with the total lost payment amount. For instance, if a customer owes $1,000 and the business determines they won’t be able to collect the debt, the write-off entry would appear as follows:
Examples of bad debt expense journal entries
Here are a few instances of journal entries for bad debt expenses:
Example 1
For their clients, a free-lance graphic designer makes posters, logos, clothing designs, and other things. They have a long-term client who abruptly stopped paying them $300 for the most recent service they received after years of working together. The independent contractor has made contact with the client to find out why they haven’t sent the payment yet. Sadly, the freelancer discovers the client’s phone number is no longer functional after three months. Their bad debt write-off entry reads as follows because they believe it is unlikely they will be able to collect the payment:
Example 2
A large number of people shop at an auto dealership, which sells luxury cars. This business is aware that three of its customers have not made their auto loan payments. When collection efforts are exhausted and attempts to recover the payments are unsuccessful, the business records them as bad debts. The three clients owe $12,000, $54,200, and $31,000 in uncollectible debt, for a combined total of $97,200. The write-off journal entry may look like this:
Accounting for Bad Debts (Journal Entries) – Direct Write-off vs. Allowance
FAQ
What is bad debt expense journal entry?
The journal entry results in a credit to the accounts receivable account and a debit to the bad debt expense account. Additionally, it might be necessary to debit the sales taxes payable account in order to reverse any associated sales tax that was charged on the initial invoice.
How do you post bad debt expense?
- Debit Bad Debts Expense to show the loss on the income statement for the business.
- Credit Receivables (to offset the amount that won’t be collected)
