What Is Bad Debt Expense?
Bad debt expense is account receivables that are no longer collectible due to customers’ inability to fulfill financial obligations. There are two distinct ways of calculating bad debt expenses – the direct write-off method and the allowance method.
The bad debts are the losses that the business suffers because it did not receive immediate payment for the sold goods and provided services. It’s recorded in the financial statements as a provision for credit losses.
What this article covers:
- How Do You Find Bad Debt Expense?
- How Do You Calculate Bad Debt?
- What Methods Are Used for Estimating Bad Debt?
- How Do You Record Bad Debt Expense?
NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.
How Do You Find Bad Debt Expense?
When a business offers goods and services on credit, there’s always a risk of customers failing to pay their bills. The term bad debt refers to these outstanding bills that the business considers to be non-collectible after making multiple attempts at collection.
It’s your decision to write off customer invoices that remain unpaid. However, if the customer is avoiding your calls, making no effort to negotiate payment terms and there are invoices that have gone unpaid for more than 90 days, you might consider writing off the invoices as bad debts
The reason for this is that it gives a more accurate picture of your financial health. Writing off these debts helps you avoid overstating your revenue, assets and any earnings from those assets.
How to Calculate Bad Debt Expense?
To calculate bad debt expense select either the direct write-off method - the invoice amount is charged directly to bad debt expense and removed from the account accounts receivable- or the allowance method - the bad debts are anticipated even before they occur and an allowance is set.
There are two methods of recognizing and calculating credit losses to the business. These include:
DIRECT WRITE-OFF METHOD
This method involves the write-off to the receivables account. When it’s clear that a customer invoice will remain unpaid, the invoice amount is charged directly to bad debt expense and removed from the account accounts receivable. The bad debt expense account is debited, and the accounts receivable account is credited.
Under this method, there is no allowance account.
There is a downside of using this method. While the direct write-off method records the exact amount of uncollectible debts and can be used to write off small amounts, it fails to uphold the GAAP principles and the matching principle used in accrual accounting.
The rule is that an expense must be recognized at the time a transaction occurs rather than when payment is made. The direct write-off method is therefore not the most theoretically correct way of recognizing bad debts.
Under this method, the bad debts are anticipated even before they occur. An allowance for doubtful accounts is established based on an estimated figure. This is the amount of money that the business anticipated losing every year.
This contra-asset account reduces the loan receivable account when both balances are listed in the balance sheet.
When accountants record sales transactions, a related amount of bad debt expense is also recorded.
This is recorded as a debit to the bad debt expense account and a credit to the allowance for doubtful accounts. The unpaid accounts receivable is zeroed out at the end of the year by drawing down the amount in the allowance account.
What Methods Are Used for Estimating Bad Debt?
According to the GAAP principles, there are two ways businesses can estimate bad debt – the sales approach, which uses a percentage of the total sales of a business for the period, or the percentage of accounts receivable method.
PERCENTAGE OF ACCOUNTS RECEIVABLE METHOD
Under this approach, businesses find the estimated value of bad debts by calculating bad debts as a percentage of the accounts receivable balance.
For example, at the end of the accounting period, your business has $50,000 in accounts receivable.
The historical records indicate an average 5% of total accounts receivable become uncollectible. Businesses also prepare an aging schedule to estimate the bad debts.
You need to set aside an allowance for bad debts account to have a credit balance of $2500 (5% of $50,000).
PERCENTAGE OF SALES METHOD
The percentage of sales of estimating bad debts involves determining the percentage of total credit sales that is uncollectible. The past experience with the customer and the anticipated credit policy plays a role in determining the percentage.
Once the percentage is determined, it is multiplied by the total credit sales of the business to determine bad debt expense.
For example, for an accounting period, a business reported net credit sales of $50,000. Using the percentage of sales method, they estimated that 5% of their credit sales would be uncollectible.
In this case, the business estimates that it would incur an amount of $2,500 ($50,000 x 5%) as bad debt expense.
How Do You Record Bad Debt Expense?
Under the allowance method of calculating bad debts, there are two general ledger accounts – bad debts, an expense account, and allowance for doubtful accounts, a contra-asset account used to offset to the accounts receivable balance.
To record the bad debt expenses, you must debit bad debt expense and a credit allowance for doubtful accounts.
|31-Aug-18||Bad Debt Expense||$170|
|Allowance for Doubtful Accounts||$170|
|02-Sep-18||Allowance for Doubtful Accounts||$170|
With the write-off method, there is no contra asset account to record bad debt expenses. Therefore, the entire balance in accounts receivable will be reported as a current asset on the balance sheet. This entails a credit to the Accounts Receivable for the amount that is written off and a debit to the bad debts expense account.
|31-Aug-18||Bad Debt Expense||$170|
Each time the business prepares its financial statements, bad debt expense must be recorded and accounted for. Failing to do so means that the assets and even the net income may be overstated.
Identifying and calculating bad debt expense also helps identify customers that default on payments more often than others. Businesses can use this to identify customers that are creditworthy and offer them discounts for their timely payments.