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.
A bad debt is a receivable that a customer will not pay. Bad debts are possible whenever credit is extended to customers. They arise under the following circumstances:
- When a company extends too much credit to a customer that is incapable of paying back the debt, resulting in either a delayed, reduced, or missing payment.
- When a customer misrepresents itself in obtaining a sale on credit, and has no intent of ever paying the seller.
The first situation is caused by bad internal processes or changes in the ability of a customer to pay. The second situation is caused by a customer intentionally engaging in fraud.
Bad debt expense is an item on a balance sheet indicating debt from a credit sale that the creditor is unable to collect. Debt becomes a bad debt expense when the creditor has made all reasonable efforts to collect the debt but has been unable to do so. Many companies set aside an allowance for bad debts to pay for bad debt expenses. While this helps, bad debt expenses still deprive a company of cash flow that is ultimately necessary to keep it in business.
A bad debt expense is a financial transaction that you record in your books to account for any bad debts your business has given up on collecting.
You only have to record bad debt expenses if you use accrual accounting principles. Bad debts are still bad if you use cash accounting principles, but because you never recorded the bad debt as revenue in the first place, there’s no income to “reverse” using a bad debt expense transaction.
Bad debt expenses make sure that your books reflect what’s actually happening in your business and that your business’ net income doesn’t appear higher than it actually is. Accurately recording bad debt expenses is crucial if you want to lower your tax bill and not pay taxes on profits you never earned.
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.
The customer takes the inventory, charges the store credit card, and doesn’t actually pay for goods when he leaves the store. The company assumes that the customer will repay the balance on his store credit card, so the company makes an account receivable for the customer. After trying to collect the balance from the customer, the company realizes that they will never be repaid this money.
The company has a few options like receivable to a collections agency, keep trying to collect it, or just write it off. When the company goes through all these steps and ends up deciding that they will never see this money again, the receivable from the customer becomes a bad debt and can be written off using either the direct write-off method or the allowance method.
Why Does Bad Debt Expense Matter?
Almost every company records a bad debt expense at some point in time. Invariably, some customers will fail to pay, which is why many companies forecast their bad debt expense based on historical averages or as a percentage of sales.
A thorough analysis of bad debt reserves over time can provide extremely valuable insights into how effectively a company is managing the credit it extends to customers.
For example, if the bad debt reserve has increased dramatically, the company may be offering credit to riskier customers, which jeopardizes the reliability of the company’s net income and cash flow. On the other hand, the company may be padding the bad debt reserve in order to make things look worse than they are, because that could make future performance look better.
Direct Write-Off vs. Allowance Method
There are two methods for reporting the amount of bad debts expense:
- direct write-off method
- allowance method
The direct write-off method requires that a customer’s uncollectible account be removed from Accounts Receivable and at that time the following entry is made: debit Bad Debts Expense and credit Accounts Receivable. 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.
The allowance method anticipates and estimates that some of the accounts receivable will not be collected. In other words, prior to knowing exactly which customers or clients will not be paying, the company will debit Bad Debts Expense and will credit Allowance for Doubtful Accounts for the estimated amount. (The Allowance for Doubtful Accounts is a contra asset account that when presented along with Accounts Receivable indicates a more realistic amount that will be turning to cash.)
For financial statement purposes the allowance method is the better method since
- the balance sheet will be reporting a more realistic amount that will be collected from the company’s accounts receivable;
- and the bad debts expense will be reported on the income statement closer to the time of the related credit sales. However, for income tax purposes the direct write-off method must be used.
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.
What is the percentage of bad debt formula?
Because you set it up ahead of time, your allowance for bad debts will always be an estimate. Estimating your bad debts usually involves some form of the percentage of bad debt formula, which is just your past bad debts divided by your past credit sales.
The formula is:
Percentage of bad debt = Total bad debts / Total credit sales
Let’s say you’ve been in business for a year, and that of the total $300,000 in credit sales you made in your first year, $20,000 ended up uncollectable. You want to set up an allowance for bad debts to take these bad debts into account ahead of time. How big should the allowance be?
First, you’d figure out your percentage of bad debts:
Percentage of bad debt = $20,000 / $300,000
Percentage of bad debt = 6.67%
If 6.67% sounds like a reasonable estimate for future uncollectible accounts, you would then create an allowance for bad debts equal to 6.67% of this year’s projected credit sales.
If you have $50,000 of credit sales in January, on January 30th you might record an adjusting entry to your Allowance for Bad Debts account for $3,335.
But this isn’t always a reliable method for predicting future bad debts, especially if you haven’t been in business very long or if one big bad debt is distorting your percentage of bad debt.