How to Calculate Bad Debt Expense: Methods & Examples

Calculating bad debt expense is important for businesses offering credit. This accounting measure provides an accurate view of a company’s financial health by anticipating uncollectible money. It impacts profitability and ensures financial statements reflect a realistic picture of assets. Accounting for these uncollectible amounts is especially important under the accrual accounting method, where revenue is recognized when earned, regardless of when cash is received.

Understanding Accounts Receivable

Accounts receivable represent money owed to a business for goods or services delivered on credit. They arise when a company makes sales but allows customers to pay later, often through invoices with specific payment terms like “Net 30 days.” It is a common business practice that facilitates sales and can attract more customers.

The amount owed is an asset on the company’s balance sheet due to a legal claim to payment. Accounts receivable are expected to convert to cash within a relatively short period, typically within a year, making them a current asset. Businesses aim to collect these amounts promptly to maintain healthy cash flow.

The risk of extending credit is that some customers may not fulfill their payment obligations. This possibility of non-payment, due to financial difficulties or disputes, creates the need to account for potential uncollectible amounts.

Direct Write-Off Method

The direct write-off method recognizes bad debt expense only when a specific account is determined to be uncollectible. This straightforward approach is used by smaller businesses or when uncollectible debt is immaterial. It is also the method required by the Internal Revenue Service (IRS) for tax purposes, as the IRS needs an accurate amount for deductions.

When an account is deemed worthless, the business removes the uncollectible amount directly from its accounts receivable. For example, if a customer owes $500 and the company determines this amount will not be collected, the business debits Bad Debt Expense for $500 and credits Accounts Receivable for $500. This action reduces the accounts receivable balance and records the loss as an expense in the period it is identified.

A disadvantage of this method is that it does not align with Generally Accepted Accounting Principles (GAAP), specifically the matching principle. The matching principle requires expenses to be recognized in the same period as the revenue they helped generate. Under the direct write-off method, the bad debt expense is recorded in a different period than when the sale occurred, which can distort the financial picture.

Allowance Methods

Allowance methods are used under accrual accounting to estimate uncollectible accounts before specific debts are identified as worthless. This proactive approach ensures financial statements accurately represent a company’s assets and profitability by matching the estimated bad debt expense to the period of related sales. These methods create a contra-asset account, Allowance for Doubtful Accounts, which reduces gross accounts receivable to their estimated net realizable value on the balance sheet.

Percentage of Sales Method

The percentage of sales method, also known as the income statement approach, estimates bad debt expense as a percentage of total credit sales for a period. This percentage is based on historical data and management’s judgment regarding past collection experiences. The method focuses on recognizing the expense in the same period as the sales, aligning with the matching principle.

For example, a company with $1,000,000 in credit sales estimates 2% will be uncollectible. The bad debt expense is calculated as $1,000,000 0.02 = $20,000. The journal entry debits Bad Debt Expense for $20,000 and credits Allowance for Doubtful Accounts for $20,000. This entry records the expense without directly affecting individual customer accounts.

Aging of Accounts Receivable Method

The aging of accounts receivable method is a balance sheet approach, focusing on estimating the ending balance needed in the Allowance for Doubtful Accounts. This method categorizes outstanding accounts receivable by age, such as 1-30 days or 31-60 days. Different percentages of uncollectibility are applied to each age category, with older receivables assigned a higher percentage due to their increased likelihood of not being collected.

The estimated uncollectible amount for each category is calculated by multiplying the receivable balance by its corresponding percentage. The sum of these amounts represents the total estimated balance required in the Allowance for Doubtful Accounts. For instance, if the total estimated uncollectible amount is $4,140 and the Allowance for Doubtful Accounts has a $100 credit balance, an adjusting entry for $4,040 is made. This entry debits Bad Debt Expense and credits Allowance for Doubtful Accounts.

When a specific account is later determined to be uncollectible under an allowance method, it is written off against the Allowance for Doubtful Accounts, not directly against Bad Debt Expense. For example, if a $100 uncollectible account is identified, the entry debits Allowance for Doubtful Accounts and credits Accounts Receivable for $100. This write-off does not impact bad debt expense at the time it occurs, as the expense was already recognized when the estimate was made.

Financial Statement Impact

Bad debt expense and the Allowance for Doubtful Accounts are presented on a company’s financial statements to provide a clear picture of credit risk and asset valuation. On the income statement, bad debt expense is reported as an operating expense, reducing the company’s net income. This reflects the cost of extending credit that proves uncollectible, directly impacting reported profitability.

The Allowance for Doubtful Accounts appears on the balance sheet as a contra-asset account. It is presented as a deduction from the gross accounts receivable balance. This results in a “net realizable value” for accounts receivable, which is the amount the company expects to collect. This adjustment is important for investors and creditors, as it offers an accurate assessment of the company’s liquidity and financial stability.