Accounting: Bad Debts

I am trying to understand how to write off bad debts for an accounting course.

We start with a bad debts allowance at the beginning of the year. We write off bad debts during the year. Then we have a year ending bad debts allowance. To calculate bad debt expense during the year, do I need all of those numbers? For example:
Bad Debt Allowance beginning of year = 10
Write offs of bad debt during year = 8
Bad Debt allowance end of year = 12

Is the bad debt expense for the year simply 12-8=4, and ignores the beginning of year figure? Would the expense that rolls up to the income statement be the 12?

What does the end of year balance tell me, as outlined above? That the bad debt expense for the year is 12, and that 10 of the 12 has already been removed from assets due to the 10 at the beginning of the year, and that 2 more need to be removed from assets?

Thank you.

Bad debt expense for the year is 10.

Start with the reserve of 10 and write off 8 leaves 2 of the original 10.

To get to 12 you have to add 10 the the remaining 2.

Once we establish the bad debt estimate at the beginning of the year, we stick to that estimate for the entire year?

Thank you for the explanation.

Bad debt is an of the end of year enty estimated on past experience. The expense is take in that year against revenues. The idea is to match expenses with the associated revenues.

The bad debt during the year (8) is the actual amount that management has determined to be bad throughout the year. In other words, those are the accounts that they’ve just plain given up on collecting.

The estimates amounts (10 and 12 here) are usually changed only at the end of the year. There’s no reason a company couldn’t change those estimate more often, but changing them requires some work to evaluate the economy, the strength of the customers, etc. - most companies only do this when they’re required to, and are only required to do so once a year (for taxes or SEC filings, for example). For the interim statements at months and quarters, they generally keep using the old estimates.

So is the following correct?

If a company overestimates its bad debt allowance at the beginning of the year, at the end of the year it must make an adjustment entry to correct this? At the end of the year when end of year bad debt allowance and true bad debt expense can be calculated, then the adjustment would simply be the beginning bad debt allowance minus the true bad debt expense?

Sound too simple…there must be a trick somewhere.

Please confirm

Thank you.

Receivables are required under generally accepted accounting principals to be stated at “fair value”. The “allowance for bad debts” is a contra asset account commonly used to accomplish this function. It is a snapshot measurement at given point in time, usually at the end of each quarter or year.

If company A has $1 million receivables outstanding, it needs to make a determination of how much of those receivables they do not expect to collect or to be bad debts. Even if the balance of the receivables is the same at each quarter end or year end, $1 million. It may not all be from the same customers, so the risk of collection may not be the same at each measurement period. So the allowance for bad debts may be $20,000 one quarter, but may be $25,000 the next depending upon the judgement of management.

So if the allowance starts at $20,000 at beginning of year 1, and there are $15,000 in write-offs through-out the year, and then the allowance is determined to be $25,000 at the end of year 1. The bad debt expense for the year would be: $25k - ($20k - $15k) = $20k

Thank you, finally makes sense.

In your example, how much of the $20k bad debt expense is already reflected in the net income? I see the balance at the beginning of the year is $20k, and the bad debt expense is also $20k, so no adjusting entry would need to be made at end of year, right? But if beginning bad debt balance had been $23k and bad debt expense was $20k, then there would have been $3k overestimate of bad debts, and that $3k would need an adjusting entry to increase the net income by $3k. Is this correct?

Thank you for helping me understand this concept.

If the beginning “allowance” balance was estimated to be $23k, and there were $15k of write-offs during the year, and the ending allowance balance was estimated to be $25k. Then the bad debt expense would be: $25-(23-15) = $17.

You are correct, thank you. The bad debt expense is $17k.

So how does that affect net income? We had allowance of $23k in begin of year, and we had only $17k bad debt expense. That is a $6k difference. Is net income overstated by 6K unless we make an adjusting entry?

Thank you.

You are correct. If we assume, in this example, that $6k is not a sufficient amount to have in your reserve for bad debts… and that $20K is the appropriate amount, then you need to beef that reserve back up. THe entry for this would be a credit to reserve for bad debts for $14k, and a debit to bad debt expense of $14k.

Ignore my previous post i misunderstood.

What you want to remember is that you recognize bad debt expense in the period that you create the reserve (unless of course you actually incur more bad debts than you reserved for) because the entry to create the reserve is:

DR Bad Debt Expense
CR Reserve for Bad Debts

What this means, is that when some deadbeat customer doesn’t pay, you don’t actually recognize an expense because you are “writing it off” by making the following Entry:

DR Reserve for Bad Debts (balance sheet account)
CR Accounts receivable

THen at the end of the year (or whatever period) you need to analyze the balance in your reserve for bad debts and decide if you need to beef it back up by:

DR Bad Debt Expense
CR Reserve for Bad Debts
Hope this helps.

So the CR Reserve for Bad Debts has an impact on net income, right?

In other words, does net income for this period increase by 6k because we overestated bad debts for same period?

Thank you.

No. There is no impact to this year’s net income until you adjust the balance back up (the third entry in my post). So we’re assuming the begging balance was $23K, that means that last year someone made a debit to Bad Debt Expense which would have impacted last year’s net income. So consider last year closed and lets look at this year:

This year we realized that $15K of our receivables were bad, so the entry we need to make is as follows (but neither of these accounts are income statement accounts so no impact to net income):

DR Reserve for Bad Debts $15K
CR Accounts Receivable $15K

This leaves our reserve balance at $8K (23-15=8). And in the example we said it was determined that the ending balance should be $25K. So we need to bump the reserve balance back up by $17K (8+17=25). The entry would be:

DR Bad Debt Expense $17K
CR Reserve for Bad Debts $17K

Since our debit is to an Expense account which is an income statement account, that affects this years net income. If, we don’t make that $17K adjustment there is no impact to this years net income (it just means that our $8k balance in the reserve is questionable and an auditor might tell us so). Also, remember that a reserve account is essentially a liability, which is not reflected on the income statment, only the balance sheet.