There might be a few bad eggs among the good among the sundry debtors of a firm or company giving rise to the problem of bad debts to be dealt with by the firm in question. The bad debts might be wholly or partially not realizable among the accounts receivables of the firm and there might be various reasons attached to such bad debts ranging from the debtors being insolvent or bankrupt, or his ill-health or the fact that his credit standing was not sufficiently enquired into at the time of giving him credit.
All this gives the very real difficulty of trying to realize the debt in full or in part at least, failing which bad debts expense which is a loss will have to be dealt with in the books of the company. Bad debts are an expense because they cannot be collected however much the company may try to do so.
In U.S. Accounting practice, the double entry or the matching principle of accounting holds that incomes or revenues and expenditures have to be recorded in the same accounting period in which they are incurred. For example, credit sales are recorded in the account called accounts receivable but it cannot be recorded at gross value because some of the debtors may not be forthcoming with the money or they may pay a part amount, and that is why accounts receivables are written at the net amount after deducting an allowance for bad debts. This is a contra-asset account and adjusting entries are made to charge the expense as uncollectible receivable. The total amount of uncollectible receivables is to be written off because it is an expense, from the Allowance for Doubtful Accounts to the bad debts Expense Account. The matching principle looks at revenues during an accounting period on the basis of its realizability as also the expenditure incurred in making those revenues possible and these expenses and revenues are recorded in the income statement for the said period.
Generally Accepted Accounting Principles or GAAP hold that bad debts are expenses that come from uncollectible accounts receivable and that they should be calculated approximately and recorded so that revenue and expense match in the month of sale and this entry should be so done that the income statement and balance sheet for that period are fair in the amount expected to come through receivables so that the matching principle is satisfied. This entry will create a contra accounts receivable balance and when it is netted against the gross amount of accounts receivable, the real value of receivables will be recorded. Because one cannot know in advance which of the accounts will be bad debts, an allowance account is made use of instead of accounts receivable and on the balance sheet this allowance is a contra asset shown as a deduction from accounts receivables, but one has to estimate the value of bad debts accruing to the allowance for each accounting period.
The invoices pertaining to bad debts have to be removed from accounts receivable and this balance is decreased by giving a debit to allowance for bad debts and a credit to accounts receivable. If the allowance for bad debts is much higher or lower than the real amount of uncollectible receivables, adjustments have to be made to the allowance account so that the real value of uncollectible accounts is recorded, increasing or decreasing the allowance as necessary. Whereas the direct method works in writing off a bad debt direct to accounts receivable and an allowance for bad debts is considered to be unnecessary. This does not satisfy Generally Accepted Accounting Principles because it is not in line with the matching principle and this method is generally used when the uncollectible invoices are said to be of a negligible amount.
There are some bad debts that can be deductible from taxes, whether they are business or non-business in nature and Section 166 of the Internal Revenue Code sets the requirements to be met to qualify for deduction. The requirements are that it should be a bona fide debt and it should not have any worth in that taxable year. The worth of the debt is again calculated to the level of collectibles, with it being necessary to determine whether the debt is wholly or partially worthless. A partially worthless bad debt may be recovered in part in future times and there are many factors taken into consideration to determine this like the credit standing of the debtor, his level of ill-health and his insolvency or bankruptcy. Section 166 also sets limits to the amount of deduction allowed. It requires that there should be an amount of tax capital to be recovered. The other qualifications are whether a debt is of business or non-business in origin with a business bad debt defined as a debt created or acquired in connection with a trade or business of the tax-payer with a business bad debt being tax-deductible whether it is wholly or partially worthless and a non-business bad debt having to be wholly worthless for it to have enough value for tax deductions.
People enter into transactions and business exchanges without knowing whether the outcome of such transactions will be good in terms of debt recovery or not. Some defaulters are genuinely not able to repay debts while some default as a matter of course. So a thorough study of the credit standing of each individual and company should be done before granting them debtor status, but this is not always possible or practicable and there are a lot of bad debts that result. These bad debts have to be properly accounted for in order to show the true financial position of the company for any given period. bad debts are said to be expenses that result from uncollectible accounts receivables and they are to be dealt with in a manner that the income statement and the balance sheet give a true account of the companys worth on any given date.
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