How to Calculate Bad Debt Expense: Methods & Examples

Bad debt expense represents money owed to a business that is unlikely to be collected. Accounting for this expense is important for accurate financial reporting, providing a clearer picture of a business’s true profitability and the actual value of its accounts receivable. This practice ensures that financial statements are not overstated with revenue that will never materialize into cash.

What Bad Debt Expense Represents

Bad debt expense is an estimate of the portion of a business’s accounts receivable that will not be collected from customers. Businesses account for this expense to adhere to the matching principle, which requires expenses to be recognized in the same period as the revenues they helped generate.

This expense is a forward-looking estimate, not the direct write-off of a specific customer’s debt at its initial recognition. Recognizing bad debt expense impacts a business’s financial health by increasing expenses on the income statement, which in turn reduces reported net income. It also affects the balance sheet by reducing the net realizable value of accounts receivable, providing a more realistic assessment of current assets.

Information Required to Determine Bad Debt Expense

Businesses need access to their accounts receivable ledger. An aging report categorizes outstanding balances into time buckets, such as 1-30 days, 31-60 days, and so on, as older debts are generally more difficult to collect.

Historical data on past uncollectible accounts is important. This data helps establish a reliable percentage of credit sales that historically become uncollectible or the likelihood of collection based on the age of receivables. The total amount of credit sales for the accounting period is also necessary, especially when estimating bad debt based on a percentage of sales.

Methods for Calculating Bad Debt Expense

Businesses primarily use two methods to calculate bad debt expense: the direct write-off method and the allowance method. The choice of method depends on the business’s size, complexity, and adherence to accounting principles. The direct write-off method is simpler but typically not permitted under Generally Accepted Accounting Principles (GAAP) for financial reporting because it does not match expenses with revenues. It is used by very small businesses or for specific tax purposes.

Under the direct write-off method, a specific customer’s account is written off as uncollectible only when it is determined to be worthless. For tax purposes, the Internal Revenue Service (IRS) allows a deduction for a business bad debt if the debt becomes worthless during the tax year, as outlined in IRS Publication 535. This approach records the expense only when the loss is confirmed. It provides no allowance for doubtful accounts on the balance sheet and can misrepresent the true value of receivables.

The allowance method, considered more accurate, has two common approaches: the percentage of sales method and the aging of receivables method. The percentage of sales method estimates bad debt expense by applying a predetermined percentage to total credit sales for the period. For example, if a business has $500,000 in credit sales and historically expects 1.5% to be uncollectible, the bad debt expense would be $7,500 ($500,000 x 0.015).

The aging of receivables method provides a more refined estimate by categorizing outstanding accounts receivable by age. Different uncollectible percentages are then applied to each age category, reflecting the increased risk of non-collection for older debts. For instance, 1% might be uncollectible for accounts 1-30 days old, while 10% might be uncollectible for accounts over 90 days old. The estimated uncollectible amount for each category is then summed to arrive at the total estimated allowance for doubtful accounts, from which the bad debt expense for the period is derived.

Recording and Reporting Bad Debt Expense

Once calculated, bad debt expense is reflected in a business’s financial statements. On the income statement, bad debt expense is presented as an operating expense. This inclusion reduces the business’s net income, providing a more realistic view of its profitability for the period.

On the balance sheet, the allowance method impacts accounts receivable through a contra-asset account called “Allowance for Doubtful Accounts.” This allowance reduces the total accounts receivable to their estimated net realizable value. For instance, if accounts receivable are $100,000 and the allowance is $5,000, the net accounts receivable reported would be $95,000. This account is an estimate and may require adjustments in future periods based on actual collections or further assessment of uncollectible amounts.