When you are preparing the financial statements for a business, you will frequently find a reference to bad and doubtful debts. It is important to ensure you understand the difference between bad debts and doubtful debts.
Bad debts are incurred when it is reasonably certain that a debtor to a business will not be paying. For example, the debtor’s business may itself have collapsed – leaving no funds in which to pay its obligations. You should treat bad debts in the same manner as any other expense.
For example, if the trial balance shows a debit entry for bad debts of $5,000 then treat this $5,000 as an expense and enter this figure in the profit and loss account. (We do not need to make a balance sheet adjustment to debtors because the debtors’ figure in the trial balance will already have had the bad debts subtracted.)
In addition to bad debts, you may also be required to account for doubtful debts. In practice, businesses have learnt from experience that some debtors will not pay – but they are not certain which debtors this applies to at the end of the year. Businesses have to make a judgement on what proportion of debtors might not pay. For example, some businesses operate in sectors of the economy which carry a higher risk of failure compared to other sectors of the economy.
In the catering or building sectors, it might be prudent to assume that a relatively high proportion of debtors should be classified as ‘doubtful’. In contrast, businesses that have debtors in a much safer and less risky sector – such as in the government sector – might need to classify a smaller proportion as ‘doubtful’.