How to Find Bad Debts Expense: Calculation Methods

Bad debts expense represents the cost a business incurs when customers fail to pay amounts owed for goods or services received on credit. This expense arises because extending credit inherently carries the risk that some accounts receivable will become uncollectible. Recognizing bad debts is important for businesses, particularly those that offer credit terms, as it helps accurately reflect their true financial performance. By accounting for these uncollectible amounts, a company can present a more realistic picture of its earnings and the value of its assets to stakeholders.

Direct Write-Off Approach

The direct write-off method is a straightforward approach to accounting for uncollectible accounts, primarily used when the amount of bad debt is considered immaterial. Under this method, a business only recognizes bad debts expense when a specific account is definitively identified as uncollectible. This occurs after collection efforts are exhausted and the balance is clearly uncollectible.

When an account is deemed uncollectible, the business directly removes the specific receivable from its books. This involves debiting the Bad Debt Expense account and crediting the Accounts Receivable account for the precise amount that will not be collected. For instance, if a $500 invoice from a customer is determined to be uncollectible, the accounting entry would be a $500 debit to Bad Debt Expense and a $500 credit to Accounts Receivable. This method immediately reduces the recorded value of accounts receivable and increases the bad debt expense on the income statement.

The direct write-off method does not attempt to estimate future uncollectible amounts. Its primary impact is on the period in which the specific account is written off, affecting revenue and receivables only at that point. However, this method does not align with Generally Accepted Accounting Principles (GAAP) because it violates the matching principle, which requires expenses to be recognized in the same period as the revenues they helped generate.

Allowance Method Approaches

The allowance method is the preferred approach under Generally Accepted Accounting Principles (GAAP) for accounting for bad debts, as it aligns with the matching principle. This method involves estimating future uncollectible accounts at the end of an accounting period. Businesses create an Allowance for Doubtful Accounts, a contra-asset account, to reduce the gross accounts receivable to their estimated net realizable value.

Recording the estimated bad debt expense under the allowance method involves debiting Bad Debt Expense and crediting Allowance for Doubtful Accounts. When a specific account is later determined to be uncollectible and written off, the entry involves debiting Allowance for Doubtful Accounts and crediting Accounts Receivable.

Percentage of Sales Method

The percentage of sales method estimates bad debts based on a percentage of total credit sales for a given period. This approach focuses on the income statement, aiming to match bad debt expense with the revenue generated from credit sales. To calculate, a business multiplies total credit sales by a historical or estimated uncollectible percentage. For example, if a company has $200,000 in credit sales and historically expects 1% to be uncollectible, the estimated bad debt expense is $2,000.

The journal entry would be a debit to Bad Debt Expense for $2,000 and a credit to Allowance for Doubtful Accounts for $2,000. This method provides a consistent way to recognize bad debt expense in relation to sales volume. It does not consider the existing balance in the Allowance for Doubtful Accounts when calculating the current period’s expense.

Percentage of Receivables Method

The percentage of receivables method estimates bad debts based on a percentage of the outstanding accounts receivable balance at the end of a period. This approach focuses on the balance sheet, aiming to ensure that accounts receivable are reported at their net realizable value. To use this method, a business applies a historical or estimated percentage to its total accounts receivable balance. For instance, if a company has $50,000 in accounts receivable and estimates 5% will be uncollectible, the desired balance in the Allowance for Doubtful Accounts is $2,500.

If the current credit balance in the allowance account is $500, the adjusting entry would be a debit to Bad Debt Expense for $2,000 ($2,500 desired balance – $500 current balance) and a credit to Allowance for Doubtful Accounts for $2,000. This method provides a more accurate valuation of accounts receivable on the balance sheet.

Aging of Receivables Method

The aging of receivables method is considered the most precise approach within the allowance method, as it categorizes accounts receivable by their age. Older receivables are more likely to be uncollectible than newer ones. Businesses create an aging schedule, which classifies outstanding balances into age brackets (e.g., 1-30 days, 31-60 days, over 90 days past due).

Different uncollectible percentages are applied to each age category. For example, 1% might be applied to accounts 1-30 days old, while 25% might be applied to accounts over 90 days old. The estimated uncollectible amount for each category is summed to determine the total desired balance for the Allowance for Doubtful Accounts. If the aging schedule calculation results in a desired allowance balance of $3,500, this target is compared to the existing allowance balance.

If the Allowance for Doubtful Accounts currently has a debit balance of $100, the adjusting entry would require a debit to Bad Debt Expense for $3,600 ($3,500 desired balance + $100 existing debit balance) and a credit to Allowance for Doubtful Accounts for $3,600. Conversely, if there was an existing credit balance of $200, the entry would be for $3,300 ($3,500 desired balance – $200 existing credit balance). This method provides a more refined estimate of uncollectible accounts.

Financial Statement Presentation

Bad debts expense is presented on the income statement as an operating expense. This expense reduces a company’s reported net income. For instance, if a company’s sales revenue is $500,000 and its calculated bad debts expense is $10,000, this $10,000 would be listed among other operating expenses, such as salaries and rent.

On the balance sheet, the “Allowance for Doubtful Accounts” is presented as a contra-asset account. This directly reduces the gross amount of accounts receivable to their net realizable value. For example, if a company has gross accounts receivable of $150,000 and an Allowance for Doubtful Accounts of $8,000, the net accounts receivable presented on the balance sheet would be $142,000.

The presentation of bad debts expense and the allowance account shows how the company is managing the risk of uncollectible accounts. The expense on the income statement directly impacts profitability, while the allowance on the balance sheet directly impacts the valuation of a significant current asset.