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What is Allowance for Bad Debt?

An allowance for bad debt is one of the most common allowances for losses made by the companies.
Arjun Kulkarni May 12, 2019
It is a question that has been dreaded by the accountancy students worldwide. But, it is one of the most basic things in this subject. How to do accounting for bad debt expense? Why does it occur? Here, we will make things sufficiently clear.

What are Bad Debts?

Let's start with the basics. A business debt is an amount of money, which an individual or a business, owes to our business. It is known as an account receivable and is an asset of the business. A bad debt is that debt which is not paid up.
Now if, one of the debtors of the business files for bankruptcy or is absconding or does not pay the amount owed to the business, it is said that the debt has gone bad. As this amount is not received by the business, it is counted as a loss and is subtracted from the total debtors or total accounts receivable in the balance sheet.

Why do we Calculate Bad Debts?

Now the bad debts are clear. The calculation is a conformance norm, as per the U.S. GAAP. The Generally Accepted Accounting Principles (GAAP) specify that it is important to make a reserve for bad debts each year. Also, it is always better to anticipate a loss than be dumbfounded. So, an allowance is also a way to prepare for an impending loss.

How do we Make the Entry for Bad Debt?

The first thing to do is decide at what percentage are you going to set the allowance. Usually, it is set at around 3% of the total debts incurred. But, the entrepreneur always has a better feel of what his business model is like and what his debtors are like.
Sometimes, a businessman gets used to a higher percentage of bad debts. In that case, he can hike the percentage of anticipated loss up. But, a more constructive solution would be to rein in the losses, and ensure that bad debts do not exceed 3% of total sales.
So, for the moment, let us assume that your total credit sales are $100,000. The allowance for bad debt on this amount would be 3% of it, i.e. $3,000.
Now, let's move on to the difficult part: the journal entry. The first journal entry is to create the ledger account for allowance for bad debts. So, the entry for this would be:

Allowance for Bad Debt A/c...................... Dr. $3,000
To Accounts Receivable A/c..................... Cr. $3,000
As bad debts are an expense or loss, they will be debited. As they reduce the asset value of the accounts receivables, that account will be credited. Next step is balance sheet posting. The account is shown on the asset side of the balance sheet, as a deduction from gross accounts receivable. Both the amounts from the journal and in the balance sheet tally.
The next question that comes to your mind is, what happens when bad debts are actually incurred? Simple. Now suppose, you have made a reserve of $3,000 and the actual bad debts are $2,000, then we overshot our estimate of annual bad debts. In this case, the journal entry will be:
Bad Debts A/c..........................................Dr. $2,000
To Allowance for Bad Debts A/c................Cr. $2,000
The explanation of the entry is very simple. According to the Golden Rules of Accountancy, a bad debt is a loss and is debited. The bad debt is deducted from the allowance; hence, the account is credited. The purpose of creating this allowance is that you are prepared for the bad debt loss, rather than experiencing an unexpected sudden loss.