Loading the player...

What is a 'Bad Debt Expense'

Bad debt expense represents the amount of uncollectible accounts receivable that occurs in a given period. Bad debt expense occurs as a result of a customer being unable to fulfill its obligation to pay an outstanding debt due to bankruptcy or other financial problems. This expense is the cost of a business having the inability to collect its debts.

BREAKING DOWN 'Bad Debt Expense'

Even if a receivable has been deemed uncollectible and written off to bad debt expense, the business retains the right to collect funds in the event of a bankruptcy court asset distribution or sudden change in the vendor’s ability to pay. Bad debt expense occurs because an entity extends credit to customers. Since a company may elect to forgo upfront payment, it incurs the risk of customers having the inability to pay for goods or services. Therefore, bad debt expense is used as a financial metric to determine if the credit and collection process is efficient.

Direct Write-Off vs. Allowance Method

There are two different application methods of recognizing bad debt expense. One is called the direct write-off method. Using this method, uncollectible accounts are specifically written off as they become uncollectible. This occurs upon receipt of a bankruptcy notice or after a specified period of time. Although the direct write-off method ensures the exact amount of uncollectible accounts is recorded, it fails to uphold the matching principle in which the expense is not always recognized in the same period as the revenue. For this reason, bad debt expense may be calculated using the allowance method. The allowance method establishes an estimated dollar amount of uncollectible accounts in the period the revenue is earned.

Calculating Bad Debt Expense Using Allowance Method

When using the allowance for uncollectible accounts, the estimated amount of bad debt expense is calculated in one of two main ways. First, an aging schedule is utilized to determine the duration of time a receivable has been outstanding. Using industry averages and company historical figures, a business takes a specific percentage of each age group and charges this estimate to bad debt expense. The specific percentage typically increases as the age of the receivable increases. This is because default risk increases and collectability decreases as a bill ages. Alternatively, a business may calculate bad debt expense by taking a percentage of net sales. This fixed rate is calculated based on the company’s historical experiences with bad debt.

Financial Statements

Bad debt expense is generally classified as a selling or administrative expense and is found on the income statement. It is one component used in the calculation of net income. The related accounts to bad debt expense, accounts receivables and allowance for doubtful accounts, are both reported on the balance sheet.

RELATED TERMS
  1. Allowance For Credit Losses

    Allowance for credit losses is an estimation of the debt that ...
  2. Bad Debt

    A debt that is not collectible and therefore worthless to the ...
  3. Net Receivables

    The total money owed to a company by its customers, minus the ...
  4. Average Collected Balance

    The average collected balance is the balance of collected funds ...
  5. Provision For Credit Losses - PCL

    In accounting, an estimation of potential losses that a company ...
  6. Net Debt

    Net debt is a metric that shows a company's overall debt situation ...
Related Articles
  1. Investing

    The Importance Of Analyzing Accounts Receivable

    While investors often focus on revenues, net income, and earnings per share, they should not overlook the importance of analyzing accounts receivable.
  2. Personal Finance

    What Millennials Should Know About Good and Bad Debt

    Can you tell the difference between good and bad debt?
  3. Personal Finance

    Good Debt Vs. Bad Debt

    Is there really such a thing as good debt and bad debt? Read on to find out.
  4. Investing

    Will Corporate Debt Drag Your Stock Down?

    Corporate debt can mean a leg up for firms, or the boot for investors. How to tell the difference.
  5. Personal Finance

    Consolidating Debt: What If You Have Bad Credit?

    Getting a debt consolidation loan is more difficult when you have bad credit. But it could still help put you on the road to improving your credit score.
  6. Retirement

    Why Retirees Are Carrying More Debt Than Ever

    As people reach retirement they are carrying more debt than ever before. Why and what to watch for.
  7. Personal Finance

    Is Debt Really a Bad Thing to Have?

    Not all debt is bad. Good debt is that which is incurred to increase your future income.
  8. Investing

    5 Ways Bad Credit Screws Up Your Life

    When your credit score slumps, many other things in your life can also start to slide downward. How to recognize the situation and start dealing with it.
  9. Personal Finance

    Debt Settlement: Cheapest Way to Get Out of Debt?

    Debt settlement is not for everyone, but for those seriously in debt it may prove an effective means of solving the problem.
RELATED FAQS
  1. Why do banks write off bad debt?

    Learn more about the practice of banks writing off bad debts and removing them from their books, including a hypothetical ... Read Answer >>
  2. Why would you look at a company's net debt rather than its gross debt?

    Learn the difference between net debt and gross debt, how to calculate debt using a company's financial statements and why ... Read Answer >>
Hot Definitions
  1. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  2. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  3. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  4. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  5. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
  6. Watchlist

    A watchlist is list of securities being monitored for potential trading or investing opportunities.
Trading Center