Accounting for Bad Debts and Depletion Method

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A bad debt occurs when one party owes another party some money that the latter might not be able to collect. The debts exist in two kinds namely business and non-business debts (Thomsett 63). A business bad debt is that which occurs from operating a business or trade and they can be deducted from business income tax return. Any other bad debt is non-business and can be deducted only as short-term capital loss. Accounting for bad debts in ordinary business differs from that of tax treatment in several respects. In ordinary business, bad debts refer mainly to losses resulting from credit transactions in the daily activities and specifically losses in trade notes and accounts receivables. In taxation, bad debts are considered more broadly and include losses on bonds, loans as well as investments debt obligations. For tax and accounting purposes bad debts may be deducted as direct credits against income after they are determined to be uncollectible or reserve for possible losses may be established.

On the other hand, depletion is the yearly charge for the utilization of natural resources. These natural resources include mineral deposits, petroleum and natural gas deposits as well as other resources depleted through extraction from the earth (Abdel-Khalik 28). These resources are recorded at the cost of a firm and include the buying price plus the expenses required to place the resource in use in that business. Despite the universal acceptance of same rules for accounting purposes, significant discrepancies regularly arise on technicalities, in contexts of detailed application and since a business uses one approach for specific purpose though it elects the other for recording purposes. This paper discusses the paradigm used in accounting for bad debts and depletion method.

How bad-debts are accounted for in customary businesses

Basically, receivables materialize as claims which are anticipated to be accumulated in hard cash (Weygandt et al 9-2). Conversely, account receivables are alleged to be the sum clients hold in arrears on an account. Credit losses in accounting are debited to Uncollectible account expense or bad debts expense. Such losses are regarded as normal and essential risk of doing business. To account for bad debts, two methods are used namely the direct write-off method and the allowance method.

The direct write-off method

According to Nikolai et al., the direct write-off method of recording uncollectible accounts has the advantages of simplicity and recording actual bad debts rather than estimates (33). When a company uses this method the bad debts expense is recorded when it is determined that a specific customer account is uncollectible. Therefore, the company writes-off the account by crediting accounts receivable and debiting bad debts expense. However, the determination and write off usually occur a later time than the period of transaction. Using the direct write-off method has the disadvantage of not attempting to match uncollectible account to sales revenue in the income statement of to reveal the cash realizable worth of accounts receivable in the balance sheet (Weygandt et al 9-3). That is the method matches the uncollectible accounts associated with past sales against revenues of the present period of sale. In using this method, the company also overstates accounts receivable associated with past sales. In addition, the method allows earnings management since the company will select the period of write-off. Due to these limitations, the direct write-off method is not recommended under general accounting principles that have been accepted. However, some businesses employ the method for financial reporting as they are expected to use it for purposes of income tax and the outcomes are not different materially from those obtained under estimation methods.

The allowance method

The company should recognize a bad debt the moment it is reasonably definite that a loss is about to occur and the associated amount can be estimated with some level of accuracy. For the purposes of financial reporting, the recommended approach for recognizing bad debts is to establish a bad debt reserve as a contra-account to the accounts receivable account (Bragg 182). For this method, a company estimates a long-term average figure of bad debt then debits the bad debt expense for this percentage of the accounts receivable for the period-end. Then it credits the uncontrollable accounts reserve contra-account. After recognizing the actual bad debt, the company debits the reserve account and credits the amount receivable account. There is no offset made to the sales account. In case of unusually large bad debts that will more than counterbalance the existing uncontrollable accounts reserve, then the reserve requires a sufficient increase to ensure that the balance in the reserve is not negative.

Via the allowance technique, bad debts outlays are documented in that similar period the correlated credit sales become documented. Often as O’Bryan asserts, this is usually done before the specific customers that will not clear their bills are identified (102). Nevertheless, it is not known that the credit sales cause uncollectible accounts and the attempt is to match the expense with the revenue collected and record them in the same time period.

There exists a number of ways that help in determining the long-term estimated amount of uncollectible accounts for the calculation that would follow. One is mostly about determining the historical average bad debts for percentage of the credit sales for one year. Another effective approach involves the calculation of the different historical percentages of bad debts based on the comparative age of the account receivable. For instance, accounts aged more than 90 days could have a historical bad debt experience of 60% and those above 30 is 35% while those below 30 are at only 5%. Although this type of experience is difficult to calculate, the result could have a considerable level of precision in the extent of the bad debt allowance for a particular firm. The level of bad debts can be estimated on the basis of the type of customer and according to their performance. For instance, it can be historically proved that government entities do not go out of business and could therefore have a lower bad debt level than other types of entities.

Estimating bad debts as a percentage of credit sales

If a company uses this estimation method the amount of debts will be a straight percentage of the present year’s credit sales (Albrecht et al 228). This percentage is a projection with basis on the experience in past years, modified according to any changes anticipated for the present year. For example, a company’s credit sales for the year of $500,000 may be expected to generate uncollectible receivables of $5,000, showing that 1% of all credit sales are supposed to be bad debts (5,000/500,000 = 1%). The company would evaluate the percentage every year, in the light of experience, to determine whether the same percentage remains reasonable. If economic conditions change for the company’s customers (such as start of a recession, posing the risk of customers not to collect debts) the percentage would be changed.

When using the percentage of sales approach, any existing balance in allowance for uncollectible receivables does not affect the amount calculated and is excluded in the adjusting entry to record uncollectible receivables account. The 1% of the sales in the current year that is estimated to be bad debts is computed and entered separately and eventually added to the prevailing balance. For example, if the prevailing credit balance is $2,500, the $5,000 will be added to make the new balance $7,500. The justification for not considering the prevailing $2, 5000 balance in allowance for uncollectible receivables is that it relates to past period’s sales and mirrors the estimate of the company.

When determining the percentage of credit sales comprising of bad debts, a company must estimate the overall amount of loss based on the industry averages or experience. Apparently, a firm that has been in operation for a number of years should be able to estimate more accurately than a new firm. Most of the established businesses use three to five years to base the estimation of losses from bad debt accounts. Although this method is a relatively straightforward approach for the income statement and abides to the matching concept, it might not offer the best estimation for the net realizable value of accounts receivable (Nikolai et al 326).The reason is that the balance in allowance account is not considered when making the adjusting entry.

Estimating bad debts as a percentage of total receivables

The other method used to estimate bad debts is to use a percentage of total receivable. When using this approach, the amount of bad debts is a percentage of the entire receivable balance at the end of that period. Assume that a company decides to use this approach and determine 10% of the $40,000 in the accounts receivable at the end of the year will finally be uncollectible. Consequently, the credit balance in allowance for uncollectible receivables should be (40,000 x 0.1) = 4,000. If there is no prevailing balance in allowance for uncollectible receivables representing the estimates of bad debts accounts left over from previous years, then the entry for $4,000 will be made. However, if a balance prevails in the account only the net amount required to make credit balance to $4,000 is added. In all instances, the final balance in allowance for uncollectible receivables should be the amount of total receivables that are estimated to be uncollectible.

When estimating uncollectible receivables expense, the percentage of sales approach focuses on estimation with a direct basis on the level of credit sales of the current year rather than the prior year’s accumulation. Conversely, in percentage of total receivables method, the focus is on the estimation of the total uncollectible receivables prevailing at the end of the period: this amount is compared to bad debts balances from previous years and the discrepancy is bad debt expense or the new uncollectible receivables generated in the current period. The two approaches are just alternative estimation methods (Albrecht et al 229). Practically, as a check, a firm would most likely use both approaches to make sure that they yield roughly reliable results.

Aging account receivables

In the previous example, the correct amount of the final allowance for uncollectible receivables balance was calculated by the application of estimated uncollectible percentage (10%) to the whole accounts receivable balance ($40,000). Using a more refined approach of estimating the proper final balance in allowance for bad debts, a business bases its computations on the period its receivables have been outstanding. With the aging accounts receivable, as the procedure is commonly known, each receivable is classified according to age. As soon as the receivables in each age categorization are totaled, each total of the receivables is multiplied by the proper uncollectible percentage (usually determined by experience), putting in mind that the chance of a receivable being collected deteriorate with age. If the allowance for bad debts estimated through this method is $5,000 and the prevailing credit balance for the account is $1500, the needed adjusting entry will be $5,000 – $1,500 = $3,500.

The aging of accounts receivable is the most accurate approach of estimating bad debts. In addition, it enables the firm to identify its problematic customers. Businesses that base their estimation of bad debts accounts on total outstanding receivables or credit sales also age their receivables in order to monitor the receivable balances of individual accounts (Albrecht et al 229).

Accounting for bad debts for tax purposes

Generally, there are differences in tax definitions and accounting and treatment of bad debts (Thomsett 63).. These differences probably give rise to differences in the value entered as bad debts expense account in the financial statements and the value deducted on the tax return for bad debts. In turn, this difference may yield different net income figures. Eventually, some of the discrepancies between business and taxable income may cancel in any one financial year while others may appear on a yearly comparison but will wash out with time. Other discrepancies are independent of yearly periods and more essentially differentiate business and taxable income.

Certain discrepancies that appear in the figure of bad debts are canceled so fast that they have no effect on the net income such as the discrepancies in classification or nomenclature. The loss that is subtracted on the tax return as a bad debt but charged to certain special loss account on financial statements will cause a discrepancy in figures of bad debts but not in the annual net income, as long as all kinds of losses involved are treated as expenses.

Other important discrepancies are those which cause a difference in the figures of annual income but eventually cancel out. In such a case, the amount of tax deductions for bad debts may equal the amount charged-off on the records, but might be allowed for the purposes of taxation in another year rather than the one that it was considered for business purposes (Bragg 539). Such kind of discrepancy may transpire when the charge off is recorded in a certain year but the tax deduction is considered in later years.

Another reason for writing down a debt on the books is the diminution in value of the debt or security; that diminution would not be enough evidence of partial worthlessness in order to allow similar deduction of bad debts for the purposes of taxation (Bragg 539). Contrariwise, even when a deduction in tax for partial worthlessness is considered, a taxpayer may postpone collecting it the time when total worthlessness can be claimed. Although the records might indicate a charge off of an amount equal to that eventually considered as bad debt deduction, differences in the yearly income figures will occur in all these cases.

Finally, some discrepancies in accounting and tax handling of bad debts cause differences in annual income that do not naturally wash out over time. For example, when collaterals that represent bad debts turn out to be worthless, the whole loss might not be deductible for the purpose of taxation because of the restrictions of the provision for capital loss (Cordes et al 79). Since the full loss will be disregarded in the books, the discrepancy between business and taxable income will never cancel out with time.

The other reason for discrepancies between book and tax figures of bad debts is the common business practice of carrying unusual or huge credits or charges directly to surplus rather than via the income account, although this practice is not recommended by many accountants. If large losses are credited directly to surplus, the total income reported for the firm will escape the liability of this credit and surpass the total taxable income. If the surplus was not charged, the expense or loss component would have to be credited against the income. Surplus credits therefore result in an overstatement of total income over a long time in the fact that aggregate earnings reported are modified significantly by the surplus credits.

The justification of surplus credits are based on the fact that the specific expense item is nonrecurring and unusual and would severely alter the income reported or that, albeit an ordinary recurring expense, the item is appropriately attributable to previous years and must not be taken as a burden on present activities. Nonrecurring and unusual credits might be depicted by the total loss of receivables in distant countries after an imposition of exchange control or an outbreak of war. A credit that may be considered to be attributable to previous years might be required if it was realized that the failure to write-off worthless accounts had caused the inadequate bad debt expense credits and an insufficient reserve.

Accounting for depletion method

Depletion accounting is the lucid, systematic allocation of the cost of unextratced natural resource to the extracted units of that natural resource (Abdel-Khalik 128).This allocation of costs to units is achieved through the units of production depletion method. In this approach, the depletion cost pertaining to each unit of extracted resource is determined through the following calculation:

(Cost of unextratced resource – estimated residual value) /estimated total units of recoverable resources = the depletion cost per unit of extracted resource.

In this calculation, cost of unextratced resource must include all costs of the natural resource until the time of the depletion cost calculation (Kieso et al 588). The estimated residual value is the estimated value of the resource property after a firm permanently discontinues the production activity at the site. For many production sites for natural resources, the residual value is zero. In other occurrences, land reclamation costs are incurred by a firm for a resource site even after production has stopped. Government regulations might compel a firm to reclaim land that the mining activities or other natural resource development have destroyed. In such a case, the estimated extra costs that are incurred by the firm when reclaiming land must be added to other costs before calculating the depletion costs.

The total units of recoverable resource figure estimated and included in the determination of depletion charge per unit are developed via engineering studies. These units are stated in terms of tons, ounces, barrels, or by the measurement method suitable for the specific natural resources. The units would include only the estimations that will be extracted with a basis on expected or present technology, expected future or present cost of development and expected or current market prices for the resource. The units of the resource that will not be extracted according to the current expectations must not be put into consideration when calculating the depletion charge per unit of the resource.

The components parts included in the calculation of depletion charge per extracted unit of the resource must be updated as new information is realized or assumptions are adjusted. All adjustments in estimates and assumptions concerning a natural resource are employed in accounting for the resource in the present as well as in the future. Adjusted assumptions must not be used as a basis for initiating retrospective changes to the accounting records of the firm.

The depletion cost per unit of resource refers to the cost of production related to each extracted unit of the resource. Additional costs of production include, supplies, labor and so on. All cost of production related to extraction of the natural resource are included in the extracted units of the resource. These units are accounted for as inventory up to the time the units are sold by the firm. During this time, the cost related to the resource units that are merchandised would be indicated as an expense on the income statement, specifically on the category of cost of resource sold.

The equipment used while extracting the natural resource must be depreciated over the speculated productive life of the resource or the estimated useful life of that equipment and this depends on the circumstance (Landefeld & Hines 1-20). For the equipment whose estimated useful life is shorter than the speculated productive life of the resource, depreciation should be done over its speculated useful life using suitable depreciation techniques. On the other hand, for the equipment with longer useful life than the speculated productive life of the resource and the equipment can be used in another production site, depreciation should be based on the estimated useful life employing a proper depreciation technique. For the equipment that cannot be used in other production sites but their useful life is longer than the productive life of the resource, depreciation should be based on the productive life of the resource. In this case, the unit of production depreciation approach is usually employed as the suitable depreciation technique because it link the depreciation recorded to the units produced.


It is apparent that there are general rules for accounting purposes, but important differences arise in practice such that the company may use one or more approaches that are more suited to the circumstance while preserving the general rules for the book purposes. When accounting for bad debts in ordinary businesses, the firms can use either the direct write-off method or allowance method though the latter is recommended by many accountants. But, the success of the approach used is determined by the way bad debts are estimated. For tax treatment, the differences in value entered as bad debts expense account is the major characteristic. On the other hand the depletion method involves the allocation of the cost of unextratced natural resource to the extracted units of that natural resource. The cost of unextratced resource must include all costs of the natural resource until the time of the depletion cost calculation.

Works Cited

Abdel-Khalik, Rashad. The Blackwell encyclopedic dictionary of accounting. Hoboken, NJ: Wiley-Blackwell, 1998.

Albrecht, Steve, Stice Earl and Stice James. Accounting: Concepts and Applications. Florence: Cengage Learning, 2010.

Bragg, Steven. Accounting reference desktop. New York, NY: John Wiley and Sons, 2002.

Cordes, Joseph, Ebel Robert and Gravelle Jane. Encyclopedia of taxation and tax policy. Washington, DC: The Urban Institute, 2005.

Kieso, Donald, Weygandt Jerry and Warfield Terry. Intermediate Accounting: IFRS Edition. New York, NY: John Wiley and Sons, 2010.

Landefeld, Steven and Hines James. National accounting for non-renewable natural resources in the mining industry. Review of Income & Wealth, 31.1 (1985):1-20.

Nikolai, Loren, Bazley John and Jones, Jefferson. Intermediate Accounting. Florence, KY: Cengage Learning, 2009.

O’Bryan, David. Financial Accounting: A Course for All Majors. Charlotte, NC: IAP, 2010.

Thomsett, Michael. Builder’s Guide to Accounting. Carlsbad, CA: Craftsman Book Company, 2001.

Weygandt, Jerry, Kimmel Paul, Trenholm Barbara and Kieso Donald. Accounting Principles. New York, NY: John Wiley and Sons, 2011.

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