Bad Debts in Accounting: Journal Entries & Examples

Bad Debts in Accounting: Complete Guide with Journal Entries

Bad debts are among the most challenging aspects of credit management in business accounting. When customers fail to pay amounts owed, businesses must recognize these uncollectible receivables through proper accounting treatment. This comprehensive guide covers everything from basic concepts to advanced journal entries for bad debts.

What Are Bad Debts in Accounting?

Bad debts refer to amounts owed to a business that become irrecoverable when customers default on their payment obligations. These arise from credit sales where the debtor becomes unable or unwilling to settle their outstanding balance.

In accounting terms, a bad debt represents:

• A receivable that cannot be collected
• An expense charged to the income statement
• A reduction in the carrying value of trade receivables

Key characteristics of bad debts:

• The amount was previously recorded as a receivable
• Reasonable collection efforts have been exhausted
• The debtor has demonstrated an inability to pay (bankruptcy, insolvency, or disappearance)

Bad Debts vs Doubtful Debts: Understanding the Difference

Journal Entry for Bad Debts Written Off

When a business confirms that a debt is irrecoverable, the following journal entry is passed:

Basic Bad Debts Entry:

Bad Debts Account       Dr.    [Amount]
    To Debtor's Account  Cr.    [Amount]
(Being bad debt written off)

Example: If ABC Ltd writes off ₹50,000 owed by XYZ Traders:

Bad Debts A/c           Dr.    ₹50,000
    To XYZ Traders A/c   Cr.    ₹50,000

Closing Entry for Bad Debts

At year-end, bad debts expense is transferred to the Profit and Loss Account:

Bad Debts A/c           Dr.    ₹50,000
    To XYZ Traders A/c   Cr.    ₹50,000

Provision for Bad Debts: Concept and Journal Entries

The Provision for bad debts (also called allowance for doubtful accounts) is an estimated amount set aside to cover potential future bad debts. This follows the prudence concept and the matching principle of accounting.

Creating Provision for Bad Debts Journal Entry

When creating Provision for the first time:

Bad Debts Expense A/c              Dr.    [Amount]
    To Provision for Bad Debts A/c  Cr.    [Amount]
Example: Creating 5% provision on debtors of ₹10,00,000:

Bad Debts Expense A/c              Dr.    ₹50,000
    To Provision for Bad Debts A/c  Cr.    ₹50,000

Adjusting Provision for Bad Debts

Increasing the Provision:

Profit & Loss Account              Dr.    [Increase]
    To Provision for Bad Debts A/c  Cr.    [Increase]

Decreasing the Provision:

Provision for Bad Debts A/c        Dr.    [Decrease]
    To Profit & Loss Account        Cr.    [Decrease]

Bad Debts Recovered: Journal Entry Treatment

When a previously written-off bad debt is subsequently collected, it constitutes bad-debt recovery—a gain for the business.

Bad Debts Recovered Journal Entry

Step 1: Reinstate the debtor

Debtor's Account              Dr.    [Amount]
    To Bad Debts Recovered A/c Cr.    [Amount]

Step 2: Record cash receipt

Cash/Bank Account             Dr.    [Amount]
    To Debtor's Account        Cr.    [Amount]

Alternative single entry method:

Cash/Bank Account             Dr.    [Amount]
    To Bad Debts Recovered A/c Cr.    [Amount]

The bad-debts-recovered account is credited to the Profit and Loss Account as income.

Bad Debts in Trial Balance: Where Does It Appear?

Bad debts can appear in the trial balance in different scenarios:

Treatment in Final Accounts

In Trading and Profit & Loss Account:

• Bad debts appear on the debit side as an expense
• Bad debts recovered appear on the credit side as income
• New/additional Provision appears on the debit side

In Balance Sheet:

• Debtors are shown at net realizable value
• Provision for bad debts is deducted from sundry debtors

Methods of Accounting for Bad Debts

1. Direct Write-Off Method

Under this method, bad debts are recognized only when specific accounts are identified as uncollectible.

Advantages:

• Simple to apply
• No estimation required

Disadvantages:

• Does not follow the matching principle
• May distort financial statements
• Not compliant with accrual accounting standards

2. Allowance Method (Provision Method)

This method estimates uncollectible accounts at each reporting period and creates a provision for them.

Approaches to estimation:

a) Percentage of Sales Method

Provision = Credit Sales × Historical Bad Debt Percentage

b) Percentage of Receivables Method

Provision = Total Receivables × Estimated Uncollectible Percentage

c) Aging of Receivables Method

Bad Debts Under Different Accounting Standards

Under IAS 39/IFRS 9

The expected credit loss (ECL) model under IFRS 9 requires entities to recognize credit losses based on forward-looking information. This represents a significant shift from the incurred loss model.

Key requirements:

• Recognize a 12-month ECL for performing receivables
• Recognize lifetime ECL when credit risk increases significantly
• Consider forward-looking economic scenarios

Under Indian Accounting Standards

Ind AS 109 follows a similar ECL approach, requiring businesses to:

• Assess credit risk at each reporting date
• Use a simplified approach for trade receivables
• Recognize impairment based on probability-weighted outcomes

Impact of Bad Debts on Financial Statements

On Income Statement

• Reduces gross profit margin
• Increases operating expenses
• Decreases net income

On Balance Sheet

• Reduces current assets (trade receivables)
• Impact working capital ratios
• Affects shareholders' equity through retained earnings

Key Financial Ratios Affected

Practical Examples with Solutions

Example 1: Comprehensive Bad Debts Adjustment

Given Information:

• Sundry Debtors: ₹2,00,000
• Existing Provision for Bad Debts: ₹8,000
• Additional bad debts to be written off: ₹5,000
• New Provision required: 5% on debtors

Solution:

Step 1: Write off additional bad debts

Bad Debts A/c               Dr.    ₹5,000
    To Sundry Debtors A/c    Cr.    ₹5,000

Step 2: Calculate the new Provision

• Revised Debtors = ₹2,00,000 – ₹5,000 = ₹1,95,000
• New Provision = 5% × ₹1,95,000 = ₹9,750
• Existing Provision = ₹8,000
• Additional Provision Required = ₹1,750

Step 3: Create additional Provision

P&L Account                        Dr.    ₹1,750
    To Provision for Bad Debts A/c  Cr.    ₹1,750

Example 2: Bad Debts Recovered Entry

Scenario: ₹10,000 written off last year is recovered this year.

Journal Entry:

Bank A/c                      Dr.    ₹10,000
    To Bad Debts Recovered A/c Cr.    ₹10,000

Closing Entry:

Bad Debts Recovered A/c       Dr.    ₹10,000
    To Profit & Loss A/c       Cr.    ₹10,000

Tax Treatment of Bad Debts

Under the Income Tax Act, bad debts are allowed as a deduction subject to specific conditions:

Section 36(1)(vii) requirements:

• The debt must have been taken into account in computing income
• The debt must be written off as irrecoverable in the accounts
• Recovery of written-off bad debt is taxable under Section 41(4)

For banks and financial institutions:

• Rural branches: Up to 5% of aggregate average advances
• Other branches: Up to 10% of aggregate average advances

Best Practices for Managing Bad Debts

Prevention Strategies

1. Credit Assessment
   • Conduct thorough credit checks
   • Set appropriate credit limits
   • Monitor customer payment patterns
2. Collection Procedures
   • Implement the aging reports review
   • Follow up promptly on overdue accounts
   • Establish clear escalation procedures
3. Documentation
   • Maintain proper records of collection efforts
   • Document customer communication
   • Keep evidence of insolvency or default

Accounting Best Practices

• Review provisions quarterly
• Use consistent estimation methods
• Document assumptions and methodologies
• Reconcile subsidiary ledgers regularly
• Implement proper internal controls

Industry-Specific Considerations

Banking and Financial Services

Banks follow specific RBI guidelines for provisioning:

• Standard assets: 0.40%
• Sub-standard assets: 15%
• Doubtful assets: 25-100%
• Loss assets: 100%

Manufacturing and Trading

• Focus on customer creditworthiness
• Implement trade credit insurance
• Regular debtor aging analysis

Service Industries

• Milestone-based billing reduces exposure
• Retainer agreements provide security
• Credit period management is critical

Frequently Asked Questions (FAQ)

Q1: What is bad debt in accounting?

Bad debt refers to money owed to a business that cannot be collected from customers who have defaulted on their payment obligations. It represents an expense recognized when receivables become irrecoverable.

Q2: What is the journal entry for bad debts written off?

Debit: Bad Debts Account, Credit: Debtor's Account. This removes the uncollectible amount from receivables and recognizes the expense.

Q3: What is the provision for bad debts?

Provision for bad debts is an estimated amount set aside from profits to cover anticipated future bad debts. It follows the prudence concept and ensures receivables are stated at net realizable value.

Q4: Where do bad debts appear in the trial balance?

Bad debts appear as a debit balance in the trial balance and are transferred to the Profit and Loss Account as an expense at year-end.

Q5: What is the difference between bad debts and Provision for bad debts?

Bad debts are confirmed irrecoverable amounts already written off, while Provision for bad debts is an estimate for potential future uncollectible amounts.

Q6: How is bad-debt recovery treated in accounting?

Bad debts recovered are credited to the Profit and Loss Account as income. The entry is: Debit Cash/Bank, Credit Bad Debts Recovered.

Q7: Can bad debts be claimed as a tax deduction?

Yes, bad debts written off in accounts can be claimed as a deduction under Section 36(1)(vii) of the Income Tax Act, subject to specified conditions.

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Q8: What is the allowance method for bad debts?

The allowance method estimates uncollectible accounts and creates a provision at each reporting period, ensuring expenses are matched with related

Related Topics to Explore

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• Journal Entries: 100+ Examples Guide
• Trial Balance: Format & Preparation
• Bank Reconciliation Statement Guide
• Depreciation Methods with Examples
• Accrual Concept in Accounting
• Current Assets Explained
• Current Liabilities Guide

External Resources

For official guidance on accounting qualifications and professional standards, visit [ACCA Global](https://www.accaglobal.com

✍️ Author Bio

This guide was written by Vijaya Swaminathan, CA, a chartered accountant with 25 years of experience and 15 yearsspecialising in IFRS training and implementation.