Bad debts are one of those possible problems that a good businessman predicts. These are technically accounts receivable which will be written off as they have less chance to be collected. They would appear under the expenses of the company in its income statement, which then reduces the profit. As bad debts are inevitable, most companies have bad debt allowance to compensate for these expenses. However, some bad debts are paid eventually. This instance is then called bad debt recovery.
Most companies set up bad debt allowance. This allowance is an estimate of how much bad debts will possibly be written off as expenses by the company based on previous records. By doing so, when the income statement of the company is done, the entry has taxable income reduced by the bad debt allowance. When it appears that an account receivable may not be collected, the company taps the said allowance to reimburse the said debt. Thus, a credit entry will be done to the accounts receivable balance and a debit will become bad debt. But when a bad debt recovery happens, a credit entry will be made in the bad debt allowance while the accounts receivable will be debited of the same amount. This “washing” done creates a great paper trail for the bad debt recovery that had occurred.
What then balances the accounts and keep the paper trail of bad debt recoveries are the “allowance for bad debts” account. This makes the crediting and debiting between the accounts receivable and the bad debt expenses “clean” and neat. It is like the bad debts’ savings account, and helps your company to continue moving forward. Further, as mentioned earlier, it aids your company by preventing it from paying high taxes based on the income percentage which will later on be converted into bad debt. However, you must remember that the efficiency of the bad debt allowance rests on your good estimate on the possible bad debts expenses of the company for that period of time. So, it is very vital that you keep records of your previous income statements and make accurate predictions of your bad debt expenses.
Photo source: http://www.flickr.com/photos/otto-yamamoto/8585219800/
Having bad debts are unavoidable so it is best that you plan ahead and prepare for it. Doing an accurate estimate of those probable expenses is essential and setting aside an account to compensate for it is a great way to handle the problem. As a businessman, educating yourself about bad debts and bad debt recovery can stabilize your profit margins.