During the normal course of business, it is regular for businesses to sell goods on credit. When businesses sell on credit, they create Accounts Receivables, which include all the details regarding the amount that is due from customers.
Normally, customers do pay back their dues. However, there are instances where a customer defaults and is unable to pay back the amount to their suppliers. This results in bad debt for the company, and hence, needs to be reflected in the company’s financial statements.
What is meant by Accounts Receivables Write-Off?
A write-off of accounts receivables is the action taken by accountants to eliminate the balance from a particular customer’s account due to the inability to the collection of the accounts.
In other words, the Accounts Receivable Write-Off is the process that reflects the fact that the amount can no longer be collected from the suppliers, and hence, it needs to be written off the books.
Accounts Receivable Write-Off takes place only when there is relative certainty that the customer would not pay back the amount, and therefore, it does not make sense to continue recording it as a Current Asset on the financial statement.
Account Receivable Write-off can take place using two approaches:
- Method 1: Using allowance for Doubtful Debts
- Method 2: Using the Direct Method
It can be seen that both these methods are equally acceptable by companies. However, it depends on the organization in context and the amount of credit sales they have.
Allowance for Doubtful Debts and Prudence Concept
In accordance with the prudence concept in accounting, accountants are supposed to prepare in advance for any unforeseeable losses.
Once the business has been in operation for a considerable time frame, they can reasonably estimate the percentage of collectibles, which might not honor their debt.
It helps the company to reasonably estimate the amount that would be declared as uncollectible from the customers. This helps them to prepare for the foreseeable loss in advance.
When an organization creates an allowance for doubtful debts, the loss is already foreseeable in the company’s financial statements. If it actually happens, it is adjusted. If all customers pay back their debts, then the allowance is unused and is subsequently carried forward to the next season.
Allowance for Doubtful Debts is one manner using which accounts proceed with the write-off for accounts receivables.
Accounts Receivable Write-off using Allowance for Doubtful Debts – Journal Entries
Using the allowance method for writing off bad debts, journal entries are made using debit in the allowance for doubtful debts and credit for accounts receivable. The journal entries are illustrated below:
|Allowance for Doubtful Debts||xxx|
Allowance for Doubtful Debts is an expense, in nature. It is contra-asset. In the same manner, bad debts or write-offs are considered contra-asset (since it is a loss from the company’s perspective).
Therefore, the journal entry above highlights this very accounting principle, as allowance for bad debts increases, whereas accounts receivable is decreased by the same amount.
When a write-off of accounts receivable is made, only the balance sheet is impacted. No changes are made to the Income Statement. This is because of the fact that the company has already recognized this loss when the Allowance for Bad Debts was first created.
The Net Realizable value in the Balance Sheet also stays the same, because the Allowance for Bad Debts and Accounts Receivable reduce by the same amount.
Example of Accounts Receivable Write-Off using the Allowance Method
Lester Inc. maintains an Allowance for Doubtful Debt account in order to account for bad debts that might occur. In the year 2019, Lester Inc. decided to write off an account with an outstanding balance of $2,000.
The journal entry required to record this particular transaction is as follows:
|Allowance for Doubtful Debts||$2,000|
Since Allowance for Doubtful Debts is a contra-asset account, it has a credit balance, by default. After the bad debt has been written off, the balance of allowance for doubtful debts might stay on the credit side, if the amount of bad debt is less than the balance on the Allowance for Doubtful Debts account.
However, if the amount of bad debt is higher than the balance on the Allowance for Doubtful Debts account, the account might end up having a debit balance.
This will be restored back to normal after the adjusting entry for the bad debt is created, because the company will subsequently add the debit balance to the required balance in the adjusting entry.
For example, let’s assume that the Allowance for Bad Debts account balance was $1,500. With the bad debt worth $2000, the amount of write-off exceeds the amount present on the Allowance for Doubtful Debts.
This means that there is a remaining balance equivalent to $500 on the debit side of Allowance for Doubtful Debts. This needs to be adjusted for using a journal entry, as follows:
|Bad Debt Expense||$2,000|
|Allowance for Bad Debts Account||$2,000|
After this adjusting entry is made, the Allowance for Bad Debts Account balance is restored back to $1500 on the credit side.
Accounts Receivable Write-off using Direct Method – Journal Entries
Direct Method of Writing off Accounts Receivables is mostly used by companies that have a relatively smaller amount of credit sales. Using this method, the company does not maintain an allowance account and directly writes off all the bad debts from the financial statements.
The company does not make journal entries for write-offs as it does under the allowance method. They simply write off the amount as an expense (or a loss) from the financial statements.
Under the direct write-off method, the company debits the bad debt expense and credits the accounts receivables.
The journal entries to show this are as follows:
|Bad Debt Expense||xxx|
The journal entry above shows that the accounts receivable is directly credited under this approach, and the corresponding amount of bad debt, is written off as an expense in the income statement.
Example of Accounts Receivable Write-Off using the Direct Method
Chester Inc. mainly operates on cash sales. They do not maintain an Allowance for Doubtful Debt account in order to account for bad debts that might occur. In the year 2019, Lester Inc. decided to write off an account with an outstanding balance of $3000. This needs to be removed from the financial statements of the company.
In order to reflect the bad debt mentioned above, it can be seen that the following journal entries are required:
|Bad Debt Expense||$3,000|
The journal entry above shows that the Accounts Receivable is reduced from the total balance, because of the defaulted payment. Likewise, the corresponding balance is charged to the Income Statement as a Bad Debt Expense for the year.
The direct method of writing off bad debts is acceptable and most companies adopt it. However, the downfall of using this approach is that it prevents companies from preparing in advance of the loss.
In the case where a significant client defaults, it might adversely impact the profitability of the given year since the company had not created an allowance for the bad debt initially.