How to Determine and Record Bad Debt Expense

Extending credit to customers is a common practice that facilitates sales. Not every credit sale results in guaranteed payment, and businesses often encounter uncollectible amounts, known as bad debt expense. Accurately accounting for these amounts is important for precise financial records and a realistic picture of a company’s financial health.

What is Bad Debt Expense?

Bad debt expense represents money owed to a business that is unlikely to be collected. This situation arises for various reasons, such as a customer’s financial difficulties, bankruptcy, or disputes over goods or services received. When a customer fails to pay an invoice, the corresponding accounts receivable effectively loses its value.

Recognizing this loss impacts a business’s financial statements. Bad debt expense reduces the value of accounts receivable on the balance sheet, ensuring that assets are not overstated. On the income statement, it is classified as an operating expense, which reduces net income and accurately reflects the costs of doing business on credit. This recognition aligns with the matching principle in accounting, which requires expenses to be recorded in the same period as the revenues they helped generate, providing a more accurate measure of profitability.

Direct Write-Off Method

The direct write-off method is a straightforward approach to recognizing bad debt expense. Under this method, a specific customer account is written off as uncollectible only when it is definitively determined that the amount will not be paid. This typically occurs after all collection efforts have been exhausted, which could be months or even years after the original sale.

This method offers simplicity, as it does not require estimations or the creation of special reserve accounts. A significant disadvantage is that it violates the matching principle because the expense is recognized when the debt is deemed uncollectible, which may be in a different accounting period than when the related revenue was earned. Consequently, it is generally not permitted under Generally Accepted Accounting Principles (GAAP) for financial reporting, except for immaterial amounts. It is, however, often the required method for federal income tax purposes.

Allowance Method

The allowance method is the preferred and GAAP-compliant approach for accounting for bad debt expense. This method adheres to the matching principle by estimating future uncollectible accounts in the same period the sales are made.

A central component is the “Allowance for Doubtful Accounts,” which is a contra-asset account. This account reduces the gross accounts receivable on the balance sheet to their net realizable value, which is the amount the company realistically expects to collect. There are two primary techniques used to determine the estimated amount for this allowance.

Percentage of Sales Method

The Percentage of Sales Method estimates bad debt expense based on a percentage of credit sales for a given period. The percentage is typically derived from historical data, representing the portion of credit sales that historically prove uncollectible. This method focuses on the income statement impact by directly calculating the expense.

Aging of Accounts Receivable Method

The Aging of Accounts Receivable Method categorizes outstanding receivables by their age, typically in 30-day increments. Different percentages of uncollectibility are then applied to each age category, with older receivables generally assigned higher percentages because they are more likely to be uncollectible. The sum of the estimated uncollectible amounts from each category represents the desired ending balance in the Allowance for Doubtful Accounts, ensuring the balance sheet reflects a realistic accounts receivable value.

Recording Bad Debt Expense

For the allowance method, the initial recognition of estimated bad debt expense involves a journal entry. The Bad Debt Expense account is debited, increasing the expense, and the Allowance for Doubtful Accounts is credited, increasing this contra-asset account. This entry is typically made as an adjusting entry at the end of an accounting period.

When a specific customer account is later deemed completely uncollectible and written off under the allowance method, a separate entry is made. The Allowance for Doubtful Accounts is debited, which reduces the reserve, and the specific Accounts Receivable account for that customer is credited, removing the uncollectible amount from the receivables balance. This write-off entry affects only balance sheet accounts and does not impact the Bad Debt Expense account at the time of the write-off, as the expense was already recognized when the estimate was initially recorded. In contrast, for the direct write-off method, when an account is determined to be uncollectible, the Bad Debt Expense account is debited, and the Accounts Receivable account is directly credited for the amount of the uncollectible debt.