How to Calculate Bad Debt: Methods and Examples

Bad debt represents money owed to a business that is unlikely to be collected. This occurs when customers fail to pay for goods or services received on credit. Understanding how to calculate and account for bad debt is important for a business’s financial health. It also ensures financial statements accurately reflect its true economic position.

Identifying Uncollectible Accounts

Before calculating bad debt, a business must determine which accounts receivable are genuinely uncollectible. An account becomes uncollectible when objective evidence indicates the debtor will not fulfill their payment obligation. This differs from an account merely being “past due,” where payment is not received by the due date but collection is still expected. Indicators of uncollectibility include customer bankruptcy, customer disappearance, or prolonged non-payment despite collection efforts. Businesses often classify accounts as uncollectible if they remain unpaid for an extended period, such as 90 to 180 days past the due date.

Methods for Estimating Bad Debt

Businesses employ different accounting methods to estimate the amount of bad debt they expect to incur. The chosen method impacts how and when the bad debt expense is recognized on a company’s financial statements. The two primary approaches are the direct write-off method and the allowance method.

The direct write-off method recognizes bad debt expense only when a specific account is definitively identified as uncollectible. For instance, if a business determines a $500 invoice will never be paid, it directly writes off that specific amount. This method is straightforward and commonly used for tax purposes in the United States because it only recognizes the expense when the debt is proven worthless. However, it generally does not align with Generally Accepted Accounting Principles (GAAP) for material amounts, as it may not match the expense with the revenue it helped generate in the same accounting period.

The allowance method is the preferred approach under GAAP because it estimates bad debt expense in the same period the related sales revenue is recognized, adhering to the matching principle. This method uses an estimate for future uncollectible accounts, which is recorded in a contra-asset account called “Allowance for Doubtful Accounts.” There are two common techniques under the allowance method: the percentage of sales method and the aging of receivables method.

The percentage of sales method estimates bad debt as a percentage of a company’s credit sales for a given period. This percentage is typically based on historical data of uncollectible accounts from past sales. For example, if a business has historically found 1% of its credit sales to be uncollectible, it would apply this rate to current credit sales. If credit sales for a period total $500,000, the estimated bad debt expense would be $5,000 ($500,000 x 0.01). This amount is then recorded as an expense, increasing the allowance for doubtful accounts.

The aging of receivables method categorizes outstanding accounts receivable by how long they have been overdue. Older accounts are assigned a higher probability of being uncollectible. For instance, current receivables might have a 1% estimated uncollectibility rate, while receivables 90 days past due might have a 25% rate.

A business prepares an aging schedule, listing each customer’s outstanding balance and sorting it into age categories like 0-30 days, 31-60 days, and over 60 days. The estimated uncollectible amount for each category is calculated by multiplying the total receivables in that category by its assigned uncollectibility percentage. Summing these amounts across all categories provides the total estimated balance needed in the Allowance for Doubtful Accounts. For example, if a company has $100,000 in receivables, with $70,000 current (1% uncollectible), $20,000 31-60 days past due (5% uncollectible), and $10,000 over 90 days past due (25% uncollectible), the estimated uncollectible amount would be $4,200.

Recording Bad Debt Expenses

Once bad debt has been identified or estimated, it must be formally recorded in a business’s financial records through journal entries. The recording process differs based on whether the direct write-off method or the allowance method is used. These entries impact both the income statement and the balance sheet, providing a clearer picture of the company’s financial standing.

Under the direct write-off method, when a specific account is deemed uncollectible, a journal entry is made. The Bad Debt Expense account is debited, and the Accounts Receivable account is credited. For example, if a $500 account from Customer X is uncollectible, the entry debits Bad Debt Expense for $500 and credits Accounts Receivable (Customer X) for $500. This reduces the company’s reported revenue and outstanding receivables.

The allowance method involves two main types of entries. First, to record the estimate of bad debt expense at the end of an accounting period, an adjusting entry is made. This entry debits Bad Debt Expense and credits Allowance for Doubtful Accounts. For instance, if the estimated bad debt is $4,200, the entry debits Bad Debt Expense for $4,200 and credits Allowance for Doubtful Accounts for $4,200. This allowance account is a contra-asset, meaning it reduces the net value of Accounts Receivable on the balance sheet.

Second, when a specific account is later determined to be uncollectible and written off, a separate entry is made against the Allowance for Doubtful Accounts. The Allowance for Doubtful Accounts is debited, and Accounts Receivable is credited. For example, if the $500 account from Customer X is written off, the entry debits Allowance for Doubtful Accounts for $500 and credits Accounts Receivable (Customer X) for $500. This write-off does not affect the Bad Debt Expense account or the income statement at the time, as the expense was recognized when the estimate was initially made.