How Is Bad Debt Expense Calculated? Methods & Examples

Bad debt expense represents the portion of accounts receivable that a business determines is unlikely to be collected from customers. When businesses extend credit, there is an inherent risk that some customers will not fulfill their payment obligations. Accurately accounting for these uncollectible amounts is important for financial reporting, ensuring financial statements truly represent assets and earnings. There are different methods businesses use to calculate and record this expense, each with distinct implications for financial presentation.

The Direct Write-Off Approach

The direct write-off method is a straightforward approach where bad debt is recognized only when a specific account is definitively identified as uncollectible. For example, if a business determines a $500 invoice from a customer will never be paid, it would debit Bad Debt Expense for $500 and credit Accounts Receivable for $500. This method is generally used by very small businesses that have minimal credit sales or for tax reporting purposes by some entities.

However, it does not align with the matching principle of accrual accounting, which requires expenses to be recognized in the same period as the revenues they helped generate. Because of this, the direct write-off method is not permissible for material amounts under Generally Accepted Accounting Principles (GAAP) for financial reporting. It can lead to a misstatement of assets and income, as the expense may be recorded long after the related revenue was recognized.

The Allowance Method Principles

The allowance method is the preferred accounting approach under GAAP for recognizing bad debt expense. This method requires businesses to estimate uncollectible accounts before specific customer accounts are identified as definitively bad. This estimation process ensures that bad debt expense is recognized in the same accounting period as the revenue it helped generate, thereby upholding the matching principle.

A central component of this method is the “Allowance for Doubtful Accounts,” which is a contra-asset account. This account reduces the gross amount of accounts receivable to its estimated net realizable value on the balance sheet. Essentially, it acts as a reserve for anticipated future uncollectible amounts, providing a more accurate portrayal of the assets a company expects to collect, and its establishment reflects a more conservative and accurate financial reporting practice.

Calculating with the Allowance Method

When using the allowance method, businesses employ various techniques to estimate uncollectible receivables, ensuring the alignment of expenses with revenues. Two common approaches are the percentage of sales method and the percentage of receivables method, which often incorporates the aging of receivables. Each method provides a basis for determining the bad debt expense for a given period.

The percentage of sales method estimates bad debt expense as a specific percentage of a company’s credit sales for a period. This percentage is based on historical data and management’s judgment regarding collectibility. For instance, if a company has $1,000,000 in credit sales and historically estimates 2% as uncollectible, the bad debt expense for the period would be $20,000 ($1,000,000 0.02). This method primarily focuses on the income statement, aiming to match the expense directly with the sales revenue earned during the period.

The percentage of receivables method, also known as the balance sheet approach, estimates uncollectible accounts based on the outstanding balance of accounts receivable at a specific point in time. A more refined version of this is the aging of receivables method, which categorizes accounts receivable by how long they have been outstanding. Older receivables are generally less likely to be collected.

For example, with aging of receivables, current receivables might be estimated as 1% uncollectible, while receivables over 90 days past due could be estimated as 50% uncollectible. To illustrate with an aging of receivables example, assume a company has accounts receivable balances categorized by age: $50,000 (0-30 days overdue, 2% uncollectible), $20,000 (31-60 days overdue, 5% uncollectible), $10,000 (61-90 days overdue, 15% uncollectible), and $9,400 (over 90 days overdue, 50% uncollectible). Calculating the uncollectible portion for each category and summing them yields a total estimated allowance for doubtful accounts of $8,200. This method directly impacts the balance sheet by valuing accounts receivable at their net realizable value.

Recording Bad Debt Expense

Once bad debt expense is calculated, it is recorded through journal entries, impacting various financial statements. The accounting treatment ensures that a company’s financial position and performance are accurately reflected.

Under the direct write-off method, when a specific account is deemed uncollectible, the journal entry involves debiting Bad Debt Expense and crediting Accounts Receivable. For instance, if a $1,000 account from Customer X is determined to be uncollectible, the entry would be: Debit Bad Debt Expense $1,000; Credit Accounts Receivable (Customer X) $1,000. This directly reduces the accounts receivable balance and records the expense in the income statement.

For the allowance method, the process involves two main types of entries. First, when the bad debt expense is estimated, an adjusting entry is made by debiting Bad Debt Expense and crediting Allowance for Doubtful Accounts. If, for example, the estimated bad debt for the period is $8,200, the entry is: Debit Bad Debt Expense $8,200; Credit Allowance for Doubtful Accounts $8,200. This increases the expense on the income statement and simultaneously increases the contra-asset allowance account on the balance sheet.

Second, when a specific customer account is later identified as uncollectible and written off, the entry involves debiting Allowance for Doubtful Accounts and crediting Accounts Receivable. This action removes the specific receivable from the books without affecting the Bad Debt Expense account, as the expense was already recognized during the estimation phase. For instance, writing off a $500 account would be: Debit Allowance for Doubtful Accounts $500; Credit Accounts Receivable (Customer Y) $500.