What Is Bad Debt?
Bad debt is an expense that a business incurs once the repayment of credit previously extended to a customer is estimated to be uncollectible. Bad debt is a contingency that must be accounted for by all businesses that extend credit to customers, as there is always a risk that payment will not be received.
- 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.
- 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.
- Bad debts can be written off on both business and individual tax returns.
Understanding Bad Debt
There are two methods available to recognize bad debt expenses. Using the direct write-off method, accounts are written off as they are directly identified as being uncollectible. This method is used in the United States for income tax purposes. However, while the direct write-off method records the precise figure for accounts that have been determined to be uncollectible, it fails to adhere to the matching principle used in accrual accounting and generally accepted 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. Therefore, in accordance with GAAP, bad debt expense must be estimated using the allowance method in the same period in which the credit sale occurs and appears on the income statement under the sales and general administrative expense section.
Because no significant period of time has passed since the sale, a company does not know which exact accounts will be paid and which will default. So an amount is established based on an anticipated and estimated figure. Companies often use their historical experience to estimate the percentage of sales they expect to become bad debt.
Recording Bad Debts
When recording estimated bad debts, a debit entry is made to a bad debt expense and an offsetting credit entry is made to a contra asset account, commonly referred to as the allowance for doubtful accounts.
The allowance for doubtful accounts nets against the total accounts receivable presented on the balance sheet to reflect only the amount estimated to be collectible. This allowance accumulates across accounting periods and may be adjusted based on the balance in the account.
Methods of Estimating Bad Debt
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 a company's expected losses to delinquent and bad debt. The statistical calculations 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 doubtful accounts, 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.
The Internal Revenue Service (IRS) allows businesses to write off bad debt on Form 1040, Schedule C if they have previously been reported as income. Bad debt may include loans to clients and suppliers, credit sales to customers, and business-loan guarantees. However, deductible bad debt does not typically include unpaid rents, salaries, or fees.
For example, a food distributor that delivers a shipment of food to a restaurant on credit in December will record the sale as income on its tax return for that year. But if the restaurant goes out of business in January and does not pay the invoice, the food distributor can write off the unpaid bill as a bad debt on its tax return in the following year.
Individuals are also able to deduct a bad debt from their taxable income if they have previously included the amount in their income or loaned out cash and can prove that they intended to make a loan at the time of the transaction and not a gift. The IRS classifies non-business bad debt as short-term capital losses.