While preparing the financial statements, you will frequently reference bad and doubtful debts. Both these accounts are charges against the profit.
However, they are not the same. Hence, it is essential to ensure you understand the difference between bad debts and doubtful debts.
It is a commonly accepted accounting principle that debts which are considered bad, or doubtful should be written off as soon as possible. However, many businesses choose to delay this process, hoping the debtor will eventually pay. This can lead to problems down the line, as the business may find it difficult to reclaim the money owed to them.
What are Bad Debts?
Bad debts are incurred when it is reasonably certain that a debtor to a business will not be paying. For example, the debtor’s business may itself have collapsed – leaving no funds in which to pay its obligations.
You should treat bad debts in the same manner as any other expense. In other words, we pass a journal entry where bad debts are debited, and debtors’ account is credited.
For example, if the trial balance shows a debit entry for bad debts of 5,000, then treat this 5,000 as an expense and enter this figure in the profit and loss account (We do not need to make a balance sheet adjustment to debtors because the debtors’ figure in the trial balance will already have had the bad debts subtracted.)
What are Doubtful Debts?
In addition to bad debts, you may also be required to account for doubtful debts. In practice, businesses have learnt from experience that some debtors will not pay – but they are not certain which debtors this applies to at the end of the year.
Businesses have to make a judgement on what proportion of debtors might not pay. For example, some businesses operate in sectors of the economy that carry a higher risk of failure than other sectors of the economy.
It is worth noting that doubtful debts have nothing to do directly with debtors’ accounts. This account is opened by debiting the profit and loss account. Simply, it is a provision like other provision accounts.
It might be prudent to assume that a relatively high proportion of debtors should be classified as ‘doubtful’ in the catering or building sectors. In contrast, businesses with debtors in a much safer and less risky sector – such as in the government sector – might need to classify a smaller proportion as ‘doubtful’.
There are many reasons why debt may be classified as bad or doubtful. The most common reason is that the debtor has failed to make any payments for a period of time. This could be because they are experiencing financial difficulty, or simply because they are trying to avoid paying the debt. Either way, it is important to act quickly in order to maximise the chances of getting the money back.
Another reason why debt may be considered bad is if the debtor is contesting the debt. This could be because they dispute the amount that is owed, or they may not believe that they owe the debt at all. In these cases, it is again important to act quickly in order to get a ruling from the courts.
Once a debt has been classified as bad or doubtful, the next step is to write it off. This means that the debt is no longer considered an asset of the company, and the company will not attempt to collect the debt. This can have a significant impact on the company’s financial statements, so it is important to consult with an accountant before taking this step.