How to Compute Bad Debt Expense: Methods & Examples

Recognizing Uncollectible Accounts

Businesses extending credit face the risk that some accounts may not be fully collected. Indicators of uncollectible accounts include a customer filing for bankruptcy, a significant period of non-payment, or ceasing operations. Economic downturns can also increase the likelihood of customers struggling to meet obligations.

Monitoring accounts receivable is important for early identification of potential bad debts. This involves regularly reviewing customer payment histories, assessing financial stability, and maintaining clear communication regarding overdue invoices. Prompt identification allows businesses to take appropriate action, such as initiating collection efforts or adjusting financial records.

Methods for Estimating Bad Debt

Estimating bad debt expense involves two approaches: the direct write-off method and the allowance method. The direct write-off method recognizes bad debt only when a specific account is deemed uncollectible and written off. This method is simpler to apply and often used by smaller businesses. However, it does not align with the matching principle of accounting, which aims to match expenses with the revenues they helped generate.

The allowance method adheres to the matching principle and is generally required under Generally Accepted Accounting Principles (GAAP) for material amounts of bad debt. This method estimates the total amount of uncollectible accounts at the end of an accounting period. Two common techniques are the percentage of sales method and the percentage of accounts receivable method. The percentage of sales method estimates uncollectible amounts based on a percentage of credit sales. The percentage of accounts receivable method, also known as the aging method, estimates uncollectible amounts by analyzing the age of outstanding receivables.

Applying the Estimation Methods

Under the direct write-off method, no estimate is made until a specific account is identified as uncollectible. For instance, if a business has a $1,000 account receivable from a customer who declares bankruptcy, the entire $1,000 is written off directly to bad debt expense. This method is simple but can distort financial results by recognizing the expense in a different period than the revenue it relates to.

The percentage of sales method, a component of the allowance method, estimates bad debt based on a historical percentage of credit sales. If a company experiences 1% of its credit sales becoming uncollectible and has $500,000 in credit sales, the estimated bad debt expense would be $5,000 ($500,000 x 0.01). This method focuses on the income statement, aiming to match the expense with the revenue generated.

The percentage of accounts receivable method, also known as the aging method, provides a more refined estimate by categorizing receivables based on their age. An aging schedule groups receivables into time brackets like 1-30 days, 31-60 days, and over 90 days. A higher uncollectible percentage is assigned to older age categories, reflecting increased risk. For example, if a business has $100,000 in receivables, with $60,000 current (1% uncollectible), $30,000 31-60 days old (5% uncollectible), and $10,000 over 90 days old (20% uncollectible), the estimated uncollectible amount would be $4,100. This $4,100 represents the desired ending balance in the Allowance for Doubtful Accounts, and the bad debt expense for the period is the amount needed to bring the allowance to this figure.

Recording Bad Debt Expense

Recording bad debt expense impacts both the income statement and the balance sheet. Under the direct write-off method, when an account is deemed uncollectible, the entry involves debiting Bad Debt Expense and crediting Accounts Receivable for the specific amount. For example, if a $500 account is written off, the entry is a debit to Bad Debt Expense for $500 and a credit to Accounts Receivable for $500. This method directly reduces the accounts receivable balance.

The allowance method uses an Allowance for Doubtful Accounts, a contra-asset account, to reduce the net realizable value of accounts receivable on the balance sheet. When bad debt expense is estimated, the entry involves debiting Bad Debt Expense and crediting Allowance for Doubtful Accounts. For instance, if the estimated bad debt is $4,100, the entry is a debit to Bad Debt Expense for $4,100 and a credit to Allowance for Doubtful Accounts for $4,100. When a specific account is later determined to be uncollectible, the entry is a debit to Allowance for Doubtful Accounts and a credit to Accounts Receivable, without affecting the Bad Debt Expense account. This approach ensures accounts receivable are presented at their estimated collectible amount.

Tax Treatment of Bad Debts

For U.S. federal income tax purposes, bad debt treatment generally differs from the allowance method used for financial accounting. The Internal Revenue Service (IRS) requires businesses to use the specific charge-off method for deducting bad debts, as outlined in Internal Revenue Code Section 166. This means a deduction is allowed only when a specific debt becomes wholly or partially worthless during the tax year.

To qualify for a deduction, the debt must be bona fide, arising from a debtor-creditor relationship with a valid obligation to pay. It must have become worthless during the tax year for which the deduction is claimed. Businesses must also demonstrate that reasonable collection steps were taken, or that such efforts would be futile. This applies to both wholly and partially worthless debts, provided the IRS is satisfied the debt is partly recoverable and charged off on the taxpayer’s books.

While the general rule for most businesses is the specific charge-off method, recent proposed IRS regulations offer an “Allowance Charge-off Method” for regulated financial companies. If finalized, this method would allow these entities to align tax bad debt deductions with their GAAP book charge-offs, creating a conclusive presumption of worthlessness for debts charged off on financial statements. This change aims to simplify compliance for banks, insurance companies, and certain affiliates, but does not alter the specific charge-off requirement for other businesses. Any recovery of a previously deducted worthless debt must be included in gross income in the year received, unless the prior deduction did not reduce taxable income.