Bad Debt and Doubtful Accounts - Explained
What are Doubtful Accounts?
Written by Jason Gordon
Updated at September 15th, 2021
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Table of Contents
What are Doubtful Accounts?How to Account for Bad DebtsDoubtful Debt vs. Bad DebtHow it Works (Example)Importance of Bad DebtAcademics Research on Allowance For Bad Debt / Doubtful AccountsWhat are Doubtful Accounts?
Bad debt occurs when a borrower or debtor defaults - fails to repay his or her loan. Such accounts are removed from the accounts receivable. You then match it against the original invoice. By doing this, you remove both the credit memo as well as the invoice from the accounts receivable statement report. Essentially, bad debt is the reduction in accounts receivable of the bank. The allowance for bad debt is usually equal to the bank loan amount that the bank does not expect to collect.
Back to: ACCOUNTING, TAX, & REPORTING
How to Account for Bad Debts
Generally, every business should have accounting books that reflect the amount of money it has. For a business that engages in lending its customers, it is important that it makes use of double-entry accounting. Here it records the amount of money the customer owes it. If some customers happen not to pay the debts they owe, then the business should create an allowance for doubtful accounts. The accounts will help protect itself from unexpected losses. This kind of journal entry will also esure that the business accurately keeps track of its book records. It will be able to estimate how much of its debt is uncollectible so that it works on how to balance the books.
Doubtful Debt vs. Bad Debt
A doubtful debt refers to an account receivable that is likely to become a bad debt in the future. Note that it is difficult to point out which specific customer is likely to default. For this reason, banks usually create what we call a reserve account for accounts receivable that is likely to become bad debts. The allowance for doubtful debts accounts shows the loans current balance that the bank expects to default, so there is adjustment done to the balance sheet to reflect that particular balance. On the other hand, bad debt refers to an account receivable that has been specifically identified as uncollectible and, therefore, it is written off. Note that when a lending institution finally confirms that a specific amount of loan balance is in default, it will go ahead to reduce the allowance for doubtful debt accounts balance. The move reduces the loan receivable balance. At this point, the loan recognized as default is not part of a bad debt estimate anymore, and its the reason why it is written off.
How it Works (Example)
Lets assume that a lending institution has a $200 million loan portfolio. It is the custom of this institution to use allowance for doubtful accounts when it comes to bad debt. The lender does an estimate and notices that about 4% ($4 million) of the loan balance is likely to default. For this reason, the lending institution decides to increase the bad debt expense in the income statement. It also increases the allowance for doubtful accounts by $4 million. Basically, the allowance for doubtful debt accounts reduces the loan receivable account when both the balances are entered in the balance sheet, making it a contra-asset account. This kind of financial reporting aids the person reading to understand the number of loans that are likely to be lost when some borrowers default.
Importance of Bad Debt
Since a number of customers are likely to default in repaying their loans, most lending institutions usually create an allowance for bad debt. The journal entry is considered to be a reserve against the number of accounts receivable that borrowers are likely not to pay. However, it is important to note that allowance for bad debt can also indicate other trends in the banking institutions or in an economy. When lenders recognize the actual bad debts, they charge them against the allowance for bad debt account. Banks use this to charge off the anticipated incremental change in bad debt, immediately they record the account receivables. Allowance for bad debts basically helps the banks to recognize bad debts early enough instead of waiting for a specific time to identify it. It also enables the recognition of bad debt expense that is more consistent from one period to the other. The banks also stuff allowance for bad debt so that they can make things look worse than they actually are. By doing this, they make the financial performance in the future look better.
Key Takeaways
- Bad debt refers to a valuation account that is used to identify that part of a banks loan that is not collectible
- Allowance for bad debt accounts helps lenders to accurately keep track of their books so that they are able to estimate how much of their debts are uncollectible
- The allowances for doubtful debts accounts show the loans current balance that the bank expects to default. Bad debt refers to an account receivable that has been specifically identified as uncollectible
- The allowance for doubtful debt accounts reduces the loan receivable account when both the balances are entered in the balance sheet, making it a contra-asset account.
Academics Research on Allowance For Bad Debt / Doubtful Accounts
- Estimation of the allowance for doubtful accounts by Markov chains, Cyert, R. M., Davidson, H. J., & Thompson, G. L. (1962). Estimation of the allowance for doubtful accounts by Markov chains. Management Science, 8(3), 287-303. Investigation of more accurate and efficient methods of estimating the allowance for doubtful accounts was begun in the early 1950's by R. M. Cyert and R. M. Trueblood [Cyert, R. M., R. M. Trueblood. 1957. Statistical sampling techniques in the aging of accounts receivable in a department store. Management Sci.3 (2, January) 185195.]. At this time, studies were confined primarily to investigation of more efficient methods of performing the first step in the estimation procedure: determining the age distribution of accounts. In particular, the applicability of statistical sampling techniques was evaluated. A number of retail establishments now use scientific sampling methods to perform the first step in the estimation of the allowance for doubtful accounts. As a continuation of research, the second phase of the allowance estimation problem was a logical area for investigation. While it did not seem likely that all of the judgment factors involved in the setting of loss expectancy rates could be eliminated, it did appear feasible to develop a scientific approach to determining these rates. Accordingly, research into this problem was initiated. This paper discusses a method which has been developed. In addition, some of the managerial implications of the method are discussed.
- Evidence of earnings management from the provision for bad debts, McNichols, M., & Wilson, G. P. (1988). Evidence of earnings management from the provision for bad debts. Journal of accounting research, 1-31.
- The allowance for uncollectible accounts, conservatism, and earnings management, Jackson, S. B., & Liu, X. (2010). The allowance for uncollectible accounts, conservatism, and earnings management. Journal of Accounting Research, 48(3), 565-601. We study the interrelation between conservatism and earnings management by examining the allowance for uncollectible accounts and its income statement counterpart, bad debt expense. We find that the allowance is conservative and that it has become more conservative over time. Conservatism may, however, facilitate earnings management. We find that firms manage bad debt expense downward (and even record incomeincreasing bad debt expense) to meet or beat analysts earnings forecasts and that conservatism accentuates the extent to which firms manage bad debt expense. Further, we find that firms manage bad debt expense downward by drawing down previously recorded overaccruals of bad debt expense that have accumulated on the balance sheet. An implication of our study is that tighter limits on the amount by which firms are permitted to understate net assets may reduce their ability to manage earnings.
- Do initial public offering firms manage accruals? Evidence from individual accounts, Cecchini, M., Jackson, S. B., & Liu, X. (2012). Do initial public offering firms manage accruals? Evidence from individual accounts. Review of Accounting Studies, 17(1), 22-40. We examine whether initial public offering (IPO) firms exercise discretion over an individual accrual account on the balance sheetthe allowance for uncollectible accountsand an individual accrual account on the income statementbad debt expense. Our research design exploits a unique disclosure requirement related to these accounts (i.e., the ex post disclosure of write-offs of uncollectible accounts), which enables us to develop refined expectation models. We provide evidence that IPO firms have conservative, not aggressive, allowances in the annual periods adjacent to their stock offerings. In fact, the average IPO firm has an allowance that is over four-times leading write-offs. We also provide evidence that IPO firms record larger, not smaller, bad debt expense and are less likely to record income-increasing bad debt expense than matched non-IPO firms. These results challenge the view that IPO firms understate receivables-related accrual accounts.
- Using mathematical probability to estimate the allowance for doubtful accounts, Schroderheim, G. (1964). Using mathematical probability to estimate the allowance for doubtful accounts. The Accounting Review, 39(3), 679-684.