What is a Bad Debt Expense
A bad debt expense is a receivable that 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 in the financial statements, which is also known as a provision for credit losses.
Bad Debt Expense
BREAKING DOWN 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.
Direct Write-Off vs. Allowance Method
There are two different methods used to recognize credit losses. Using the direct write-off method, uncollectible accounts are written off as they become uncollectible - which 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 rule is that an expense must be recognized at the time a transaction occurs rather than when payment is made. For this reason, bad debt expense is calculated using the allowance method, which provides an estimated dollar amount of uncollectible accounts in the same accounting period in which the revenue is earned.
Calculating Bad Debt Expense Using Allowance Method
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 credit losses is established based on an anticipated and estimated figure. A company will debit bad debts expense and credit this allowance. The allowance for doubtful accounts is a contra-asset account within accounts receivable, which means that it reduces the loan receivable account when both balances are listed in the balance sheet. This allowance can accumulate across accounting periods and may be adjusted based on the balance in the account.
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.