How to Calculate Bad Debts Expense: Methods & Formulas

Bad debts expense represents the portion of accounts receivable a business expects it will never collect from customers who purchase goods or services on credit. Accurately accounting for these uncollectible amounts is important for reflecting a company’s real profitability.

If uncollectible accounts are not considered, revenues and assets may appear inflated, misleading investors and creditors. Properly estimating and recording bad debts provides a more realistic valuation of accounts receivable on the balance sheet, allowing for a more accurate assessment of a business’s earnings and its ability to generate cash from operations.

Direct Write-Off Method Explained

The direct write-off method recognizes bad debts only when a specific account is deemed uncollectible. This straightforward approach directly removes the uncollectible amount from accounts receivable. For instance, if a customer files for bankruptcy and an invoice will not be paid, the business writes off that debt.

This method is simpler for small businesses due to its reactive nature, avoiding estimations and recording expense only when an actual loss occurs. However, it does not align with accrual accounting principles, which match expenses with revenues in the same period.

For example, a December sale might be deemed uncollectible the following May; the bad debt expense would be recorded in May, not December. This timing mismatch can distort financial performance. While not acceptable for financial reporting under accrual accounting standards, this method is sometimes used by smaller entities or for tax purposes. For federal income tax purposes, a business deducts a bad debt in the year it becomes wholly worthless, aligning with the direct write-off concept for tax reporting, as outlined in IRS Publication 535.

Allowance Method Approaches

The allowance method estimates bad debts before specific accounts become uncollectible, aligning with accrual accounting’s matching principle. It uses a contra-asset account, “Allowance for Doubtful Accounts,” to reduce the reported value of accounts receivable on the balance sheet. This allowance represents the estimated uncollectible amount of receivables.

Percentage of Sales Method

The percentage of sales method estimates bad debts based on a percentage of current period credit sales. This income statement-focused approach matches bad debts expense with sales revenue generated in that period. Businesses use historical data to determine a reasonable percentage (e.g., 0.5% to 2% of credit sales) historically found to be uncollectible.

For example, if a company has $500,000 in credit sales and estimates 1% will be uncollectible, the bad debts expense would be $5,000 ($500,000 0.01). This amount is recorded as an expense, increasing the allowance for doubtful accounts. This method is simple to apply and provides a consistent way to recognize bad debts alongside sales activity.

Percentage of Receivables Method (Aging of Receivables)

The percentage of receivables method, also known as the aging of receivables method, estimates bad debts based on the age of outstanding accounts receivable. This balance sheet-focused approach ensures accounts receivable are reported at their net realizable value—the amount expected to be collected. To apply this method, a company prepares an “aging schedule” categorizing each outstanding receivable by how long it has been unpaid.

Common aging categories include current (0-30 days), 31-60 days past due, 61-90 days past due, and over 90 days past due. Older receivables are assigned a higher percentage of uncollectibility, as they are less likely to be collected. For instance, 2% might be estimated for current receivables, while 50% or more could be estimated for accounts over 90 days past due.

After categorizing and applying percentages, the sum of these estimated uncollectible amounts represents the desired ending balance in the Allowance for Doubtful Accounts. If the aging schedule indicates a total estimated uncollectible amount of $10,000 and the current allowance balance is $2,000, an $8,000 adjustment is made to reach the target balance. This method provides a more precise estimate of uncollectible accounts by considering the specific risk associated with the age of each receivable. The percentage of sales method primarily estimates the expense for a period, while the aging method estimates the balance needed in the allowance account, which then determines the expense for the period.

Journal Entries for Bad Debts

After calculating bad debts expense, journal entries record these amounts. The recording process differs based on the method used and reflects the impact on a business’s assets and expenses.

With the direct write-off method, a specific customer account is removed once deemed uncollectible. The journal entry debits Bad Debts Expense and credits Accounts Receivable for that customer. For example, a $500 invoice from Customer A deemed worthless results in a debit to Bad Debts Expense for $500 and a credit to Accounts Receivable (Customer A) for $500.

The allowance method involves two main journal entries: one for initial estimation and another for actual write-off. The initial estimation, determined by methods like percentage of sales or aging of receivables, debits Bad Debts Expense and credits Allowance for Doubtful Accounts. For example, if estimated bad debts for the period are $5,000, the entry debits Bad Debts Expense for $5,000 and credits Allowance for Doubtful Accounts for $5,000.

When a specific account is later determined uncollectible and written off, the entry debits Allowance for Doubtful Accounts and credits Accounts Receivable for that customer. This write-off does not directly affect the Bad Debts Expense account, as the expense was already recognized during the initial estimation. For instance, if Customer B’s $300 account is written off, the entry debits Allowance for Doubtful Accounts for $300 and credits Accounts Receivable (Customer B) for $300.

If an account previously written off is unexpectedly collected, a two-step process records the recovery. First, the specific account is reinstated by debiting Accounts Receivable and crediting Allowance for Doubtful Accounts, which reverses the original write-off. Second, the cash collection is recorded by debiting Cash and crediting Accounts Receivable. For example, if Customer C pays a $200 account previously written off, the first entry debits Accounts Receivable (Customer C) for $200 and credits Allowance for Doubtful Accounts for $200. The second entry debits Cash for $200 and credits Accounts Receivable (Customer C) for $200.