Credit sales are a normal phenomenon of any business and we all know that an element of risk is associated with credit sales. No matter how careful the business owner is in checking the credibility of the customers, there are always some who do not pay or fail to pay. However, inspite of being aware of this fact, the seller continues to sell on credit as the amount gained from increased sale volumes is more than the loss suffered due to non payment by some customers.
Bad Debts are those debts against which payment could not be realised even after reasonable efforts to recover the money. So basically a debt is declared bad only when reasonable efforts to recover the said debt have failed.
There can be three instances in the case of Bad Debts:
- Bad Debts written off;
- Bad Debts Recovered; and
- Bad Debts provided for i.e. Provision for Bad Debts
Let us look into each of these categories one by one
1. Bad Debts written off
If a customer’s balance, i.e. his debt is declared bad, then the amount needs to be written off (deducted) from the Debtors (or sales) ledger. This is done as per the principle of prudence as a bad debt appearing in the Debtors’ Balance will represent itself as an asset and thus misstate the financial reports. So the amount needs to be written off immediately in the books of accounts by crediting the Customer’s Account in the Debtors ledger and debiting the Bad Debts Account in the general ledger. At the end of the accounting period, the balance in the Bad Debts Account is transferred to the Profit and Loss Account’s debit side, so that the Bad Debts can finally be accounted as a loss.
Let us see an example for Bad Debts Written off to understand its accounting:
Mr A, a debtor of Rs 3000 in the books of Mr B, became insolvent and an amount of Rs 1400 could only be realised from him. The remaining balance is to be written off in the books. Show journal entries in the books of Mr. B
Journal entries in the Books of Mr B
For Bad Debt and realisation of cash:
Bad Debts Account – Dr Rs 1600 (3000-1400)
Cash Account – Dr Rs 1400
To Mr. A Account Rs 3000
For transfer of the bad debt to Profit and Loss Account at the end of the accounting period:
Profit and Loss Account Dr Rs 1600
To Bad Debts Account Rs 1600
2. Recovery of Bad Debts
Sometimes it happens that a debt which was written off as bad in the current or a previous accounting period is eventually realised later. In such cases, the customer’s account in the debtors’ ledger is debited again with the amount realised and Bad Debt Recovery Account is credited in the general ledger. Then Cash Book is debited with the amount received and the customer’s account in the debtors’ ledger is credited. Some people may recommend a shortcut method where they directly debit the Cash Book and credit the Bad Debt Recovery Account in the general ledger, totally omitting to make any entry in the customer’s account. This method may be convenient but is not advised as there is no record in the customer’s account from whom the amount was realised.
Let us see an example to understand the accounting of recovery of Bad Debts:
Mr A had written off the dues from Mr B of Rs 500 as bad debts in the previous accounting period. However Mr B paid the amount in full in the current year. Show the journal entries to be passed in the current year.
Journal entries in the books of Mr A
First we will reinstate the balance of the Mr. B’s (customer’s) account by recording the bad debt recovery
Mr B Account – Dr. Rs 500
To Bad Debts Recovery Account Rs 500
Then we will pass the entry of realisation of cash from Mr. B
Cash Account – Dr Rs 500
To Mr. B Account Rs 500
Finally at the year end we will have to transfer the income from bad debt recovery to the Profit and Loss Account by the following entry
Bad Debts Recovery Account- Dr Rs 500
To Profit and Loss Account Rs 500
The third instance i.e Provision of Bad and Doubtful Debts is in itself a very big topic to cover so I will cover it in a different post. Till then keep reading and keep learning J