What is a bad debt expense?
A bad debt is recognized when admissible no longer collectible because a customer is unable to meet their obligation to pay an unpaid debt due to bankruptcy or other financial problems. Businesses that extend credit to their customers report bad debts as an allowance for bad debts on the balance sheet, also known as an allowance for credit losses.
Key points to remember
- Bad debts are an unfortunate cost of doing business with customers on credit, as there is always a risk of default inherent in providing credit.
- The direct write-off method records the exact amount of uncollectible accounts as they are specifically identified.
- In order to comply with the matching principle, bad debts must be estimated using the provision method for the same period in which the sale takes place.
- There are two main methods of estimating an allowance for bad debt: the percentage of sales method and the chronological accounts receivable method.
Understanding Bad Debt Expenses
Bad debts are generally classified as selling and general administration expenses and are found on the income statement. The recognition of bad debts leads to a compensatory reduction of accounts receivable on the balance sheet, although companies retain the right to raise funds if circumstances change.
Direct write-off method vs allocation method
There are two different methods of posting bad debts. Use direct to write method, uncollectible accounts are written off directly as an expense as they become uncollectible. This method is used in the United States for income tax purposes.
However, while the direct write-off method records the exact amount of uncollectible accounts, it does not follow the matching principle used in accrual accounting and generally accepted accounting principles (GAAP). The matching principle requires that expenses be matched against related revenues in the same accounting period in which the revenue transaction takes place.
For this reason, bad debts are calculated using the allowance method, which provides an estimate of the dollar amount of bad accounts during the same period in which the income is earned.
Recording Bad Debt Expenses Using the Allowance Method
The provision method is an accounting technique that allows companies to take into account anticipated losses in their financial state limit the overestimation of potential income. To avoid an account overstatement, a business will estimate how much of its current period sales receivables it expects to be past due.
Since no significant period of time has passed since the sale, a business is not sure which accounts receivable will be paid and which will default. So a provision for bad debts is established on the basis of a forecast and estimated figure.
A business will debit bad debts and credit this allowance account. The allowance for doubtful accounts is a counter-asset account which is deducted from accounts receivable, meaning it reduces the total value of accounts receivable when both balances are recorded on the balance sheet. This provision can accumulate over several accounting periods and can be adjusted according to the account balance.
Methods of estimating bad debt expense
There are two main methods for estimating the dollar amount of accounts receivable that should not be collected. Bad debt expense can be estimated using statistical modeling such as probability of default to determine expected losses due to bad debts and bad debts. Statistical calculations can use historical data from the company as well as from the industry as a whole. The specific percentage will generally increase as the age of the receivable increases, to reflect the increased risk of default and the decrease in collectability.
Alternatively, a bad debt expense can be estimated by taking a percentage of net sales, based on the company’s historical bad debt experience. Companies regularly modify provisions for credit losses to match current statistical modeling provisions.
Aging method of accounts receivable
The age ranking method groups all unpaid accounts receivable by age and specific percentages are applied to each group. The aggregate of results for all groups is the estimated unrecoverable amount. For example, a business has $ 70,000 in accounts receivable less than 30 days past due and $ 30,000 in accounts receivable more than 30 days past due. Based on previous experience, 1% of accounts receivable less than 30 days will not be collectable and 4% of accounts receivable less than 30 days will be uncollectible. Therefore, the business will report an allowance and bad debt expense of $ 1,900 (($ 70,000 * 1%) + ($ 30,000 * 4%)). If the following accounting period results in an estimated allowance of $ 2,500 based on unpaid accounts receivable, only $ 600 ($ 2,500 – $ 1,900) will constitute the bad debt expense in the second period.
Percentage of sales method
The sales method applies a fixed percentage to the total dollar sales amount for the period. For example, based on previous experience, a business can expect 3% of net sales to be unrecoverable. If the total net sales for the period is $ 100,000, the company establishes an allowance for doubtful accounts of $ 3,000 while simultaneously reporting $ 3,000 of bad debt. If the following accounting period results in net sales of $ 80,000, an additional $ 2,400 is recorded in the allowance for doubtful accounts and $ 2,400 is recorded in the second period in bad debt. The overall balance of the allowance for doubtful accounts after these two periods is $ 5,400.