How to Estimate Bad Debt Expense for Your Business

Bad debt expense is money owed to a business that is unlikely to be collected. This uncollectible amount directly impacts a company’s financial health. Understanding how to account for these potential losses is important, especially for businesses that offer credit to customers. While two main accounting methods exist for handling bad debt, this article focuses on the estimation techniques used within the allowance method, which aligns with Generally Accepted Accounting Principles (GAAP).

The Allowance Method for Bad Debt Estimation

The allowance method involves estimating uncollectible accounts before specific customer balances are identified as worthless. This approach is preferred under GAAP because it adheres to the matching principle. The matching principle requires that expenses be recognized in the same accounting period as the revenues they helped generate, providing a more accurate picture of a period’s net income.

To implement this method, businesses establish an account called “Allowance for Doubtful Accounts,” sometimes referred to as a “Bad Debt Reserve.” This account is a contra-asset account, meaning it reduces the gross value of accounts receivable on the balance sheet.

Using the Percentage of Sales Method

The percentage of sales method is an income statement approach where bad debt expense is estimated as a percentage of a period’s total credit sales. This percentage is derived from a company’s historical data on uncollectible credit sales. For example, if a business historically finds that 1.5% of its credit sales are not collected, this rate serves as the basis for the current period’s estimate.

To calculate the bad debt expense using this method, multiply the total credit sales for the period by the estimated uncollectible percentage. For instance, if a company has $500,000 in credit sales during a quarter and estimates 1.5% will be uncollectible, the bad debt expense recorded would be $7,500 ($500,000 x 0.015). This amount is then debited to Bad Debt Expense and credited to the Allowance for Doubtful Accounts. This method does not directly consider the current age or specific collectibility of individual outstanding customer balances.

Using the Aging of Accounts Receivable Method

The aging of accounts receivable method is a balance sheet approach that estimates the uncollectible portion of existing accounts receivable. This method begins by preparing an “aging schedule,” which categorizes all outstanding customer balances based on how long they have been overdue. Categories include current (not yet due), 1-30 days past due, 31-60 days past due, 61-90 days past due, and over 90 days past due. The longer an account has been outstanding, the less likely it is to be collected, so progressively higher uncollectible percentages are applied to older categories.

For example, a company might estimate 1% of current receivables as uncollectible, 5% for 1-30 days past due, 15% for 31-60 days past due, and 40% for accounts over 90 days past due. After applying these percentages to each category’s total, the sum represents the desired ending balance for the Allowance for Doubtful Accounts. If the aging schedule indicates a desired allowance balance of $12,000 and the current Allowance for Doubtful Accounts has a credit balance of $2,000, then a bad debt expense of $10,000 ($12,000 – $2,000) would be recorded to bring the allowance to the correct level. This entry would debit Bad Debt Expense and credit the Allowance for Doubtful Accounts. This method provides a more precise reflection of the current collectibility of a company’s receivables because it directly assesses the risk associated with each age group.

Importance of Managing Bad Debt

Actively managing and tracking bad debt extends beyond mere estimation, impacting various aspects of a business’s operations and financial health. Accurate bad debt estimations are important for precise financial reporting, ensuring that revenue and asset values are not overstated. These estimates also provide insights into a company’s credit risk exposure, helping management assess the effectiveness of its credit policies. From a tax perspective, businesses can generally deduct bad debts that become worthless from their taxable income, subject to specific IRS rules and documentation requirements for proving worthlessness.

Proactive management of bad debt also plays a role in strategic planning. Businesses can implement clear credit policies, such as setting credit limits for customers and performing credit checks, to minimize potential losses. Prompt invoicing and consistent follow-up on overdue payments, perhaps through a structured collections process, can significantly improve collection rates. Regular monitoring of accounts receivable, often facilitated by accounting software, allows businesses to identify and address at-risk accounts before they become uncollectible.