How to Calculate Bad Debt Expense for Your Business

Businesses often extend credit to customers, allowing them to pay for goods or services at a later date. While most customers fulfill their payment obligations, some accounts may become uncollectible, representing a loss for the business. This uncollectible amount is recognized as bad debt expense, reflecting the cost of doing business on credit.

Understanding Bad Debt Expense

Bad debt expense represents the portion of accounts receivable that a business expects to never collect from customers. Under the accrual basis of accounting, revenues and expenses are recognized when they are earned or incurred, regardless of when cash is exchanged. This aligns with the matching principle, which dictates that expenses should be recorded in the same accounting period as the revenues they helped generate. Therefore, businesses estimate and record uncollectible accounts in the period when the related sales are made.

Recording bad debt expense at the time of sale provides a more accurate representation of a company’s net realizable value of accounts receivable. It also allows stakeholders to assess the true profitability of sales made on credit by considering the associated collection risk.

Direct Write-Off Method

The Direct Write-Off Method is one approach to accounting for uncollectible accounts. This method recognizes bad debt expense only when a specific customer account is identified as uncollectible and is written off. For example, if a customer’s $500 account is determined to be uncollectible, the business would debit Bad Debt Expense for $500 and credit Accounts Receivable for $500. This entry directly removes the uncollectible amount from the accounts receivable balance.

This method is simpler to apply because it does not require estimations of future uncollectible amounts. It is often used by smaller businesses with few credit sales or when uncollectible amounts are immaterial. While straightforward, this method does not align with the matching principle under Generally Accepted Accounting Principles (GAAP) because the expense is recorded in a period later than the sale that generated the receivable. For tax purposes, the Internal Revenue Service (IRS) permits the direct write-off method for deducting business bad debts, as outlined in IRS Publication 535.

Allowance Method

The Allowance Method is the preferred approach for accounting for bad debt expense under GAAP because it adheres to the matching principle. This method involves estimating uncollectible accounts at the end of each accounting period and recording an expense, even before specific accounts are identified as uncollectible. The estimate is recorded by debiting Bad Debt Expense and crediting Allowance for Doubtful Accounts, a contra-asset account that reduces the reported value of Accounts Receivable. When a specific account is later deemed uncollectible, the Allowance for Doubtful Accounts is debited and Accounts Receivable is credited, with no further impact on Bad Debt Expense in that period.

One common approach within the Allowance Method is the Percentage of Sales Approach. This method estimates bad debt expense as a percentage of total credit sales for a period. For instance, if a business determines that 1% of its $100,000 in credit sales will likely be uncollectible, the estimated bad debt expense would be $1,000 ($100,000 x 0.01). The journal entry would be a debit to Bad Debt Expense for $1,000 and a credit to Allowance for Doubtful Accounts for $1,000. This approach focuses on the income statement, aiming to accurately match bad debt expense with the revenue generated in the same period.

The Aging of Accounts Receivable Approach is another technique within the Allowance Method. This method involves analyzing the age of individual accounts receivable balances, classifying them into categories like 1-30 days past due, 31-60 days past due, and so on. A higher percentage of uncollectibility is assigned to older receivables, as they are less likely to be collected. For example, if $50,000 of receivables are 1-30 days old with a 2% estimated uncollectibility, and $10,000 are 61-90 days old with a 10% estimated uncollectibility, the calculation would be ($50,000 0.02) + ($10,000 0.10) = $2,000. This $2,000 represents the desired ending balance in the Allowance for Doubtful Accounts.

To illustrate, if the Allowance for Doubtful Accounts currently has a $200 credit balance, and the aging analysis indicates a desired balance of $2,000, then a bad debt expense of $1,800 ($2,000 – $200) would be recorded. The journal entry would be a debit to Bad Debt Expense for $1,800 and a credit to Allowance for Doubtful Accounts for $1,800. This approach focuses on the balance sheet, ensuring that accounts receivable are reported at their estimated net realizable value. Both methods require estimation based on historical data, industry trends, and current economic conditions to provide a reliable figure for uncollectible accounts.

Impact on Financial Statements

The calculation and recognition of bad debt expense influence a company’s financial statements. On the Income Statement, bad debt expense is reported as an operating expense, reducing a company’s net income. This reflects the cost associated with extending credit as part of normal business operations. For example, if a company records $5,000 in bad debt expense for a period, its reported operating income will be $5,000 lower.

On the Balance Sheet, the Allowance for Doubtful Accounts reduces Accounts Receivable. This allowance is a contra-asset account, meaning it has a credit balance and is subtracted from the gross accounts receivable balance. This ensures Accounts Receivable are reported at their net realizable value, the amount the company expects to collect. For instance, if a company has $100,000 in gross accounts receivable and an Allowance for Doubtful Accounts of $8,000, the net accounts receivable reported on the balance sheet would be $92,000.