Bad Debt Expense Definition and Methods for Estimating (2024)

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.

Key Takeaways

  • 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.
  • 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 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.
  • The allowance method creates a contra asset allowance account that reduces the net amount of accounts receivable.

Bad Debt Expense Definition and Methods for Estimating (1)

Understanding Bad Debt Expense

When a company makes a credit sale, it books a credit to revenue and a debit to an account receivable. The problem with this accounts receivable balance is there is no guarantee the company will collect the payment. For many different reasons, a company may be entitled to receiving money for a credit sale but may never actually receive those funds.

Because the company may not actually receive all accounts receivable amounts, Accounting rules requires a company to estimate the amount it may not be able to collect. This amount must then be recorded as a reduction against net income because, even though revenue had been booked, it never materialized into cash.

This expense is called bad debt expenses, and they are generally classified as sales and general administrative expense. Though part of an entry for bad debt expense resides on the balance sheet, bad debt expense is posted to 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 circ*mstances change.

How to Calculate Bad Debt Expense

There are two different methods used to recognize bad debt expense. Using the direct write-off method, uncollectible accounts are written off directly to expense as they become uncollectible. On the other hand, the allowance method accrues an estimate that gets continually revised.

Direct Write-Off Method

The direct write-off method is used in the U.S. for income tax purposes. However, while the direct write-off method records the exact amount of uncollectible accounts, it fails to uphold 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.

The major problem with the direct write-off is the unpredictability of when the expense may occur. Consider a company that has a single customer that has a material amount of pending accounts receivable. Under the direct write-off method, 100% of the expense would be recognized not only during a period that can't be predicted but also not during the period of the sale.

The entries to post bad debt using the direct write-off method result in a debit to 'Bad Debt Expense' and a credit to 'Accounts Receivable'. There is no allowance, and only one entry needs to be posted for the entry receivable to be written off.

Allowance Method

The allowance method is an accounting technique that enables companies to take anticipated losses into consideration in itsfinancial statementsto 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.

How to Estimate 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.

Example of Bad Debt Expense

As part of its 2021 annual report, Amazon reported details in its notes to the financial statements regarding accounts receivables, allowance for doubtful accounts, and bad debt expense. Although bad debt expense is not explicitly called out in its financial statements, assumptions can be made based on footnote disclosures about their allowance estimates.

Bad Debt Expense Definition and Methods for Estimating (2)

From the financial statement snippet above, the important words to note is "net and other". This means that the gross amount of accounts receivable have been reduced. Instead of showing the gross accounts receivable and an offsetting allowance for doubtful accounts, Amazon has combined these two amounts. At the end of 2021, Amazon reported $32.89 billion of accounts receivable.

More information about this balance is disclosed in the notes below.

Bad Debt Expense Definition and Methods for Estimating (3)

Based on the note disclosure, Amazon's allowance for doubtful accounts is $1.1 billion. This means the gross amount of accounts receivable is actually over $1 billion higher than what the company is showing on its financial statements. However, due to conservatism, this balance has been reduced.

In addition, it's important to note the change in the allowance from one year to the next. Because the allowance went relatively unchanged at $1.1 billion in both 2020 and 2021, the entry to bad debt expense would not have been material. However, the jump from $718 million in 2019 to $1.1 billion in 2022 would have resulted in a roughly $400 million bad debt expense to reconcile the allowance to its new estimate.

What Are Examples of Bad Debt Expense?

Consider a company going bankrupt that can not pay for all of its bills. Some of the people it owes money to will not be made whole, meaning those people must recognize a loss. This situation represents bad debt expense on the side that is not going to collect the funds they are owed.

Is Bad Debt an Expense or a Loss?

Technically, "bad debt" is classified as an expense. It is reported along with other selling, general, and administrative costs. In either case, bad debt represents a reduction in net income, so in many ways, bad debt has characteristics of both an expense and a loss account.

Where Is Bad Debt Expense Reported?

Bad debt expense is reported within the selling, general, and administrative expense section of the income statement. However, the entries to record this bad debt expense may be spread throughout a set of financial statements. The allowance for doubtful accounts resides on the balance sheet as a contra asset. Meanwhile, any bad debts that are directly written off reduce the accounts receivable balance on the balance sheet.

The Bottom Line

Bad debt expense is a natural part of any business that extends credit to its customers. Because a small portion of customers will likely end up not being able to pay their bills, a portion of sales or accounts receivable must be ear-marked as bad debt. This small balance is most often estimated and accrued using an allowance account that reduces accounts receivable, though a direct write-off method (which is not allowed under GAAP) may also be used.

Bad Debt Expense Definition and Methods for Estimating (2024)

FAQs

Bad Debt Expense Definition and Methods for Estimating? ›

Bad debt expense is used to reflect receivables that a company will be unable to collect. Bad debt can be reported on financial statements using the direct write-off method or the allowance method. The amount of bad debt expense can be estimated using the accounts receivable aging method or the percentage sales method.

What is a method of estimating bad debts expense? ›

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.

What are the methods of calculating bad debt expense? ›

What is the bad debt expense formula? To calculate bad debt expenses, divide your historical average for total bad credit by your historical average for total credit sales. This formula gives you the percentage of bad debt, which represents the estimated portion of sales deemed uncollectible.

What is the allowance method for estimating and reporting bad debt expense? ›

The allowance method is an estimate of the amount the company expects will be uncollectible made by debiting bad debt expense and crediting allowance for uncollectible accounts. If a specific account becomes uncollectible, it will debit allowance for doubtful accounts and credit accounts receivable.

What is the method for recording bad debt expense? ›

The portion that a company believes is uncollectible is what is called “bad debt expense.” The two methods of recording bad debt are 1) direct write-off method and 2) allowance method.

Which method of estimating bad debts is required by GAAP when the amount of bad debt is material? ›

If bad debt expense is expected to be material for the current accounting period, estimating an allowance for doubtful accounts and use of the allowance method should be required when determining the net realizable value of accounts receivable.

What is the balance sheet approach for estimating bad debt? ›

The balance sheet method (also known as the percentage of accounts receivable method) estimates bad debt expenses based on the balance in accounts receivable. The method looks at the balance of accounts receivable at the end of the period and assumes that a certain amount will not be collected.

How do managers estimate bad debt expense based on? ›

The allowance is based on management's best estimate for the bad debt expense – i.e. the dollar amount of receivables that will not be paid by customers – which is calculated using either the aging method or the percentage of sales method, or a combination of the two considering how closely tied they are to each other.

How to calculate bad debt expense using aging method? ›

The other option for calculating a bad debt expense formula is the ageing of accounts receivable formula. This involves taking the total amount of outstanding invoices and dividing it by your average monthly sales, from which you can calculate an estimated bad debt expense.

What happens if a company fails to record estimated bad debts expense? ›

Answer and Explanation:

If an entity does not record bad debts, the expenses are understated and he or she may end up having to pay the extra income tax due to high net income.

Is allowance for bad debts an estimate? ›

The allowance, sometimes called a bad debt reserve, represents management's estimate of the amount of accounts receivable that will not be paid by customers. If actual experience differs, then management adjusts its estimation methodology to bring the reserve more into alignment with actual results.

What is an example of allowance method bad debt? ›

Based on historical data and trends, XYZ Company estimates that 5% of the accounts receivable will be uncollectible. Here's how the allowance method would work in this example: Estimate the amount of uncollectible accounts: Uncollectible accounts = 5% * $100,000 = $5,000.

What is the allowance method for bad debts the end of the period? ›

Using the allowance method for bad debts, the end of the period adjusting entry for estimated bad debts is: Debit Accounts Receivable and credit Alowance for Doubtful Accounts. Debit Allowance for Doubtul Accounts and credit Bad Debts Experse.

What method must be used to record bad debt losses for tax purposes? ›

Accrual Method

The business will be able to deduct the uncollectible bad debt expenses from gross receipts, provided that the bad debts have been reported to the IRS.

Which method of estimating bad debt expense focuses on balance sheet relationships? ›

The balance sheet method (also known as the percentage of accounts receivable method) estimates bad debt expenses based on the balance in accounts receivable. The method looks at the balance of accounts receivable at the end of the period and assumes that a certain amount will not be collected.

What are the two methods of estimating the uncollectible accounts expense? ›

The percentage of sales method and the accounts receivable aging method are the two most common ways to estimate uncollectible accounts. Companies can also use specific identification, historical evidence, and or risk assignment to determine the estimate.

What is the direct method of accounting for bad debt? ›

Under the direct write off method, when a small business determines an invoice is uncollectible they can debit the Bad Debts Expense account and credit Accounts Receivable immediately. This eliminates the revenue recorded as well as the outstanding balance owed to the business in the books.

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