Financial Accounting &

Analysis
Accounting estimates: Useful life of non-
current assets, Impairment of non-current
assets, Bad debts, Provision for obsolete
and slow-moving stock, Revalued amounts
of non-current assets, Provision for pension
benefits, Depreciation.
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(Bad Debts)

This topic will teach you about bad debts and the accounting treatment for them

Learning Objectives

At the end of this topic, you will be able to:

Understand What are bad debts
Identify the two methods of recognizing bad debts
Develop an understanding of the provisions of law
Understand the treatment of Recovery of Bad Debts
Understand the allowance of bad debts allowed for banks and
financial institutions
Understand the Treatment as per Accounting Standard
Understand the Accounting Treatment
Identify the Methods for Estimating Bad Debt
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(Bad Debts)

Definition
A bad debt is a receivable that a customer will not pay. Bad debts are possible whenever credit is extended to
customers. They 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.

Bad debt is a contingency that must be accounted for by all businesses that extend credit to customers, as there
is always a risk that payment won't be collected.
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Understanding Bad Debt

There are two methods available to recognize bad debt expenses.

Using the direct write-off method, accounts are written off as they are directly identified as being uncollectible.
However, while the direct write-off method records the precise figure for accounts that have been determined to
be uncollectible, it fails to adhere to the matching principle used in accrual accounting and generally accepted
accounting principles (GAAP)

The matching principle requires that expenses be matched to related revenues in the same accounting period in
which the revenue transaction occurs. Therefore, in accordance with GAAP, bad debt expense must be estimated
using the allowance method in the same period in which the credit sale occurs and appears on the income
statement under the sales and general administrative expense section.

Because no significant period of time has passed since the sale, a company does not know which exact accounts
will be paid and which will default. So an amount is established based on an anticipated and estimated figure.
Companies often use their historical experience to estimate the percentage of sales they expect to become bad
debt.
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Allowance for Bad Debts as per law

A Deduction is allowed in for the debt related to business and profession if the same has become irrecoverable
in the previous financial year. If the Loans lent by banking or money lending concerns are not able to recover the
debts in full or part thereof, a deduction may be allowed. The eligibility of the deduction is on the existence of
debts which is irrecoverable is totally under the law or through courts. The conditions laid down in Income Tax
Act, 1961 u/s 36(2) should be fulfilled before any allowance for bad debts is allowed. The conditions are:

• The debt or loan should be for the business or profession of the assessee and the said debt or loan should be
for the relevant accounting year. Any debt which does not relate to the assessee business or profession, the
deduction is not allowed in case of such debt.

• In the case of “Girdhari Lal Gian-chand vs C.I.T (1917) 79 T.R 561 (Allahabad),” it is settled that if a debt due
from retired partners is irrecoverable then the assessee cannot write off and claim the same as a deduction
since it is a capital loss.

• An assessee can take the deduction in respect of those debts only which have been included in the
computation of the Income Tax Return in the current period or any previous financial year. In case of the
money lending business, the money lent in the ordinary course of business should be considered.
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(Bad Debts)

Allowance for Bad Debts

• The deduction claimed as the bad debts against any debt or loan or any part of it thereof should have actually
been bad in the accounting year.

• An assessee will only be eligible to take the deduction in respect of those debts only which they have written
off from the books of accounts in the previous financial year in which the deduction is also claimed.

Bad Debts of Discontinued Business

Bad Debts of a discontinued business which is already discontinued before the accounting year starts, cannot be
claimed as a deduction from the profit of the continued business of the assessee. As per section 36(2)(iii) if bad
debts have already been written off in the books of accounts but they are not allowed as a deduction by A.O on
the ground that the debt is still having a possibility of recovery. Any such debt or part of debt should be allowed
as a deduction in the year in which is becoming irrecoverable.
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Recovery of Bad Debts

Bad Debts Recovered

If in any previous year, the debt has been written off as bad and the relevant deduction has also been claimed
but later on the same debt is recovered in full or part, then the amount so recovered will be included as income
of the financial year in which such amount has recovered. If in any previous year, the assessee has written off a
part of the debt and the said deduction was also allowed by the Assessing Officer and in future, some money is
received from the debtors, then the amount so recovered will be treated as a normal realization of debts. If the
amount recovered doesn’t exceed the expected, then the remaining amount will be treated as bad debts. If the
amount received exceeds the recoverable amount, then the excess amount received will be treated as the
income in the financial year of the receipt.

Provision for Bad and Doubtful Debts

As per section 36(1)(viia) of the Income Tax Act, 1961 only banks and financial institutions are allowed deduction
in respect of the provisions made for bad and doubtful debts. No other assessee is allowed to claim the
deduction on the provision of bad debts.

The limits on which the deduction is allowed to the banks and financial institutions are:
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(Bad Debts)

Allowance for Bad Debts

Bank Type Deduction Allowed
Indian Banks 7.5% of adjusted total income +
10% of average aggregate
advances made by rural branches
Explanation
Indian Bank means any bank
which is not a foreign bank and is
a banking company incorporated
in India.
Adjusted Total Income – Gross
total income before deduction
under section 36(1)(viia).
Average aggregate advances*

Foreign Banks 5% of adjusted total income Adjusted Total Income – Gross

Public Financial Institution, State
Financial Corporation
5% of adjusted total income
total income before deduction
under section 36(1)(viia).
Adjusted Total Income – Gross
total income before deduction
under section 36(1)(viia).
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(Bad Debts)

Treatment as per Accounting Standard

Note: Average aggregate advances can be computed in the following steps:

• Calculate separately all the advances made by every rural branch

• Calculate average advances made by branch i.e advances made divided by no of months outstanding

• Total of all the average advances by every branch

Treatment as per Accounting Standard

As per Accounting Standard 29 “Provisions, Contingent Liabilities and Assets” an assessee must account for the
provisions that occur in the ordinary course of business. Since the provisions are disallowed sometimes by the
Income Tax Department, it creates a timing difference between the books of accounts and books as per the I.T
Act.

Thus, an assessee will also need to create Deferred Tax Assets/Liability accordingly. An assessee must only create
a deferred tax asset/liability only if the timing difference of the transaction is temporary in nature and has the
possibility of getting reversed in the future.
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(Bad Debts)

Accounting Treatment for Bad Debts Expenses

There are two methods of accounting for bad debts:

• Allowance for doubtful accounts method, and

• Direct write-off method

Direct Write-off

The method involves a direct write-off to the receivables account. Under the direct write-off method, bad debt
expense serves as a direct loss from uncollectibles, which ultimately goes against revenues, lowering your net
income. For example, in one accounting period, a company can experience large increases in their receivables
account. Then, in the next accounting period, a lot of their customers could default on their payments (not pay
them), thus making the company experience a decline in its net income. Therefore, the direct write-off method
can only be appropriate for small immaterial amounts.
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Accounting Treatment for Bad Debts Expenses

Bad Debt Allowance Method

When it comes to large material amounts, the allowance method is preferred compared to the direct write-off
method. However, many companies still use the direct write-off for small amounts. The reason for the
preference is because the method involves a contra asset account that goes against accounts receivables. A
contra asset account is basically an account with an opposite balance to accounts receivables and is recorded on
the balance sheet

The reason why this contra account is important is that it exerts no effect on the income statement accounts. It
means, under this method, bad debt expense does not necessarily serve as a direct loss that goes against
revenues.

The three primary components of the allowance method are as follows:

• Estimate uncollectible receivables.

• Record the journal entry by debiting bad debt expense and crediting allowance for doubtful accounts.
• When you decide to write off an account, debit allowance for doubtful accounts and credit the corresponding
receivables account
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Accounting Treatment for Bad Debts Expenses under direct write-off method
The journal set of entries for bad debts is as follows;
Bad Debts A/C Debit Nominal Debit all Losses

 To Debtor’s A/C Credit Personal Credit the giver

(Amount written-off as bad debt being transferred to bad debts account)

The closing journal entry for bad debts would be as follows;

Profit and Loss A/C  Debit

 To Bad Debts A/C  Credit

(Transferring bad debts to the profit an loss account)

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(Bad Debts)

Accounting Treatment for Bad Debts Expenses

Event Debit Credit

Recording Bad Debt Bad Debts Account Debtor’s account

Transfer of Bad Debt to Income Profit and Loss Account Bad Debts Account
Statement

For provision for bad debts journal entries

Year 1

Profit and Loss A/C  Debit

 To Provision for Bad Debts A/C  Credit

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(Bad Debts)

Accounting Treatment for Bad Debts Expenses

In the Second/Subsequent Year

For Provision for Bad Debts Journal entries (If a new provision is more than old)

Profit and Loss A/C  Debit

 To Provision for Bad Debts A/C  Credit

Provision for Bad Debts A/C  Debit

To Profit and Loss A/C  Credit

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(Bad Debts)

Methods for Estimating Bad Debt

Methods for Estimating Bad Debt

Two primary methods exist for estimating the amount of accounts receivables not expected to be collected.

Bad debt expense can be estimated using statistical modeling such as default probability to determine a
company's expected losses to delinquent and bad debt. The statistical calculations utilize historical data
from the business as well as from the industry as a whole. The specific percentage will typically increase as
the age of the receivable increases, to reflect increasing default risk and decreasing collectability.

Alternatively, a bad debt expense can be estimated by taking a percentage of net sales, based on the
company’s historical experience with bad debt. Companies regularly make changes to the allowance for
doubtful accounts, so that they correspond with the current statistical modeling allowances.
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(Bad Debts)

Methods for Estimating Bad Debt - Accounts Receivable Aging Method

The aging method groups all outstanding accounts receivable by age and specific percentages are applied to
each group. The aggregate of all groups' results is the estimated uncollectible amount.

For example, a company has ₹70,000 of accounts receivable less than 30 days outstanding and ₹30,000 of
accounts receivable more than 30 days outstanding. Based on previous experience, 1% of accounts
receivable less than 30 days old will not be collectible and 4% of accounts receivable at least 30 days old will
be uncollectible.

Therefore, the company will report an allowance and bad debt expense of ₹1,900 (( ₹70,000 x 1%) +
(₹30,000 x 4%)). If the next accounting period results in an estimated allowance of ₹2,500 based on
outstanding accounts receivable, only ₹600 (₹2,500 - ₹1,900) will be the bad debt expense in the second
period.
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(Bad Debts)

Percentage of Sales Method

The sales method applies a flat percentage to the total amount of sales for the period. For example, based
on previous experience, a company may expect that 3% of net sales are not collectible. If the total net sales
for the period is ₹100,000, the company establishes an allowance for doubtful accounts for ₹3,000 while
simultaneously reporting ₹3,000 in bad debt expense.

If the following accounting period results in net sales of ₹80,000, an additional ₹2,400 is reported in the
allowance for doubtful accounts, and ₹2,400 is recorded in the second period in bad debt expense. The
aggregate balance in the allowance for doubtful accounts after these two periods is ₹5,400.
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(Bad Debts)
Summary
In this topic, you learnt:
Understood What are bad debts – receivable which customer will not pay, due to credit
offered, can happen due to inability to pay or fraud.
Identified the two methods of recognizing bad debts – direct write-off and allowance
method
Developed an understanding of the provisions of law - relevant section of Income Tax
Act discussed.
Understood the treatment of Recovery of Bad Debts – to be treated as income if earlier
bad debt deduction claimed
Understood the allowance of bad debts allowed for banks and financial institutions –
only banks and financial institutions allowed to claim deduction for provision that too
for certain percentage
Understood the Treatment as per Accounting Standard – provision to be accounted,
deferred tax asset/liability creation
Understood the Accounting Treatment - 2 methods-direct write off and allowance, the
journal entries for same discussed