Bad Debt Expense
Bad debt expenses are the losses that businesses suffer when their customers do not repay their debts or fail to meet their financial obligations. In other words, bad debt expense is the amount of money that a business must write off as a loss because it cannot collect the debt. Those debts are seen as a detrimental factor to a business’s profitability and financial stability.
This type of expense is typically recorded when a company determines that a customer is unlikely to pay an outstanding debt, either because the customer is experiencing financial difficulties or because the company has exhausted all means of collecting the debt.
Bad debt expenses are generally considered a normal and necessary part of doing business, and companies may take steps to minimize them, such as implementing credit checks and collection policies. These expenses are also factored into a company’s financial statements, including its income statement and balance sheet.
How to Calculate Bad Debt Expense
To calculate bad debt expense, a company needs to estimate the amount of its accounts receivable that will not be collected. This estimation process involves two methods: the allowance method and the direct write-off method.
- Allowance Method
Under the allowance method, a company estimates the amount of uncollectible accounts at the end of each accounting period and records an adjusting entry to increase its bad debt expense and reduce its allowance for doubtful accounts. The steps to calculate bad debt expense under this method are:
- Determine the percentage of accounts receivable that are expected to be uncollectible based on historical data, economic conditions, and other relevant factors.
- Apply this percentage to the total accounts receivable balance to determine the estimated amount of uncollectible accounts.
- Record an adjusting entry to increase bad debt expense and reduce the allowance for doubtful accounts by the estimated amount of uncollectible accounts.
- Direct Write-Off Method
Under the direct write-off method, a company waits until a specific account becomes uncollectible and then records the bad debt expense. This method is simpler but does not provide a reliable estimate of the total amount of uncollectible accounts. The steps to calculate bad debt expense under this method are:
- Identify specific accounts that are considered uncollectible.
- Write off the uncollectible accounts by debiting the bad debt expense account and crediting the accounts receivable account.
Example of Bad Debt Expense
Assume that a company has total accounts receivable of $100,000, and based on historical data and economic conditions, management estimates that 5% of these accounts will be uncollectible.
Under the allowance method, the company would record the following journal entry at the end of the accounting period:
Debit Bad Debt Expense for $5,000
Credit Allowance for Doubtful Accounts for $5,000
This would increase the bad debt expense account and decrease the allowance for doubtful accounts by $5,000. The company would report a net accounts receivable balance of $95,000 on its balance sheet.
If the company uses the direct write-off method, it will wait until a specific account is determined to be uncollectible before recording the bad debt expense. For example, if a customer owes $2,000 and is not able to pay, the company will record the following journal entry:
Debit Bad Debt Expense for $2,000
Credit Accounts Receivable for $2,000
This would decrease the accounts receivable balance by $2,000 and increase the bad debt expense account by $2,000. However, this method may not accurately reflect the total amount of uncollectible accounts and is not preferred under generally accepted accounting principles.
Why Businesses Record Bad Debt Expense?
Bad debt expense generally arises from credit sales, where businesses extend credit to their customers on the presumption that they will pay back the debt at a later date. Unfortunately, not all customers pay their debts, which generates bad debt expense. It can be a significant problem for businesses that rely heavily on credit sales, especially those in the retail and service industries. If left unchecked, bad debt expense can lead to a deterioration of a company’s cash flow.
Overall, bad debt expense is an unavoidable cost for businesses that offer credit sales. As such, effective credit management policies and practices, such as credit checks and debt recovery procedures, are essential to minimize bad debt expense and maintain a healthy financial position.