What is a Bad Debt Expense?
A bad debt expense is recognized when a receivable is no longer collectible because a customer is unable to fulfill their obligation to pay an outstanding debt due to bankruptcy or other financial problems. Companies that extend credit to their customers report bad debts as an allowance for doubtful accounts on the balance sheet, which is also known as a provision for credit losses.
Bad Debt Expense
Understanding Bad Debt Expense
Bad debt expenses are generally classified as a sales and general administrative expense and are found on the income statement. Recognizing bad debts leads to an offsetting reduction to accounts receivable on the balance sheet—though businesses retain the right to collect funds should the circumstances change.
- Bad debt expense is an unfortunate cost of doing business with customers on credit, as there is always a default risk inherent to extending credit.
- The direct write-off method records the exact amount of uncollectible accounts as they are specifically identified.
- In order to comply with the matching principle, bad debt expense must be estimated using the allowance method in the same period in which the sale occurs.
- There are two main ways to estimate an allowance for bad debts: the percentage sales method and the accounts receivable aging method
Direct Write-Off vs. Allowance Method
There are two different methods used to recognize bad debt expense. Using the direct write-off method, uncollectible accounts are written off directly to expense as they become uncollectible. This method is used in the U.S. for income tax purposes.
However, while the direct write-off method records the exact amount of uncollectible accounts, it fails to uphold the matching principle used in accrual accounting and generally agreed accounting principles (GAAP). The matching principle requires that expenses be matched to related revenues in the same accounting period in which the revenue transaction occurs. For this reason, bad debt expense is calculated using the allowance method, which provides an estimated dollar amount of uncollectible accounts in the same period in which the revenue is earned.
Recording Bad Debt Expense Using the Allowance Method
The allowance method is an accounting technique that enables companies to take anticipated losses into consideration in its financial statements to limit overstatement of potential income. To avoid an account overstatement, a company will estimate how much of its receivables from current period sales that it expects will be delinquent. Because no significant period of time has passed since the sale, a company does not know which exact accounts receivable will be paid and which will default. So, an allowance for doubtful accounts is established based on an anticipated, estimated figure.
A company will debit bad debts expense and credit this allowance account. The allowance for doubtful accounts is a contra-asset account that nets against accounts receivable, which means that it reduces the total value of receivables when both balances are listed on the balance sheet. This allowance can accumulate across accounting periods and may be adjusted based on the balance in the account.
Methods of Estimating Bad Debt Expense
Two primary methods exist for estimating the dollar amount of accounts receivables not expected to be collected. Bad debt expense can be estimated using statistical modeling such as default probability to determine its expected losses to delinquent and bad debt. The statistical calculations can utilize historical data from the business as well as from the industry as a whole. The specific percentage will typically increase as the age of the receivable increases, to reflect increasing default risk and decreasing collectibility.
Alternatively, a bad debt expense can be estimated by taking a percentage of net sales, based on the company’s historical experience with bad debt. Companies regularly make changes to the allowance for credit losses entry, so that they correspond with the current statistical modeling allowances.
Accounts Receivable Aging Method
The aging method groups all outstanding accounts receivable by age, and specific percentages are applied to each group. The aggregate of all groups' results is the estimated uncollectible amount. For example, a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding. Based on previous experience, 1% of accounts receivable less than 30 days old will not be collectible and 4% of accounts receivable at least 30 days old will be uncollectible. Therefore, the company will report an allowance and bad debt expense of $1,900 (($70,000 * 1%) + ($30,000 * 4%)). If the next accounting period results in an estimated allowance of $2,500 based on outstanding accounts receivable, only $600 ($2,500 - $1,900) will be the bad debt expense in the second period.
Percentage of Sales Method
The sales method applies a flat percentage to the total dollar amount of sales for the period. For example, based on previous experience, a company may expect that 3% of net sales are not collectible. If the total net sales for the period is $100,000, the company establishes an allowance for doubtful accounts for $3,000 while simultaneously reporting $3,000 in bad debt expense. If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $2,400 is recorded in the second period in bad debt expense. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400.