A bad debt is a receivable that a customer will not pay. Bad debts arise under the following circumstances:
- When a company extends too much credit to a customer that is incapable of paying back the debt, resulting in either a delayed, reduced, or missing payment.
- When a customer misrepresents itself in obtaining a sale on credit, and has no intent of ever paying the seller.
The first situation is caused by bad internal processes or changes in the ability of a customer to pay. The second situation is caused by a customer intentionally engaging in fraud.
There are two ways to record a bad debt, which are:
- Direct write-off method. If you only reduce accounts receivable when there is a specific, recognizable bad debt, then debit the Bad Debt expense for the amount of the write off, and credit the accounts receivable asset account for the same amount.
- Allowance method. If you charge an estimated amount of accounts receivable to bad debt expense in the same period when you record related revenue, then debit the Bad Debt expense for the amount of the estimated write-off, and credit the Allowance for Doubtful Accounts contra account for the same amount.
The direct write-off method is not the best approach, because the charge to expense may occur several months after you recorded the related revenue, so there is no matching of revenue and expense within the same period (the matching principle).The allowance method has the advantage of matching expected bad debts to revenues, even if you don't know exactly which accounts receivable will not be collectible.
It is not entirely true that a bad debt will never be collected. It is possible that a customer will pay extremely late, in which case the original write off of the related receivable should be reversed, and the payment charged against it. Do not create new revenue to reflect the receipt of a late cash payment on a written-off receivable, since doing so would overstate revenue.