How to Record Bad Debt Expense: A Step-by-Step Process

Bad debt expense represents uncollectible money owed to a business. When a company sells goods or services on credit, customers may not pay their invoices due to various reasons. Accurately recording bad debt expense is important for financial reporting, as it ensures a realistic portrayal of a company’s financial health. It prevents overstating assets and income, which is necessary for stakeholders to make informed decisions.

Understanding Bad Debt Expense

Recording bad debt expense is necessary to align with fundamental accounting principles, specifically the matching principle and the principle of conservatism.

The matching principle dictates that expenses should be recognized in the same accounting period as the revenues they helped generate. For bad debt, this means the expense of uncollectible accounts from credit sales should be recorded in the same period the sales revenue was recognized. The principle of conservatism suggests that when faced with uncertainty, accountants should choose the method that is least likely to overstate assets and income, thus anticipating losses rather than gains.

Direct Write-Off Method

The direct write-off method recognizes bad debt expense only when a specific account is determined to be uncollectible. This approach is used by businesses with immaterial amounts of uncollectible receivables or those using cash basis accounting.

When an account is deemed uncollectible, the journal entry involves debiting Bad Debt Expense and crediting Accounts Receivable. For example, if a $500 invoice is determined to be uncollectible, the entry would be: Debit Bad Debt Expense $500; Credit Accounts Receivable $500. This directly reduces the accounts receivable balance and records the loss.

If a previously written-off account is later collected, the recovery requires two journal entries. First, the account is reinstated by debiting Accounts Receivable and crediting Bad Debt Expense (or a revenue account). Second, the cash collection is recorded by debiting Cash and crediting Accounts Receivable. For instance, if the $500 account is recovered, the entries would be: Debit Accounts Receivable $500, Credit Bad Debt Expense $500; then Debit Cash $500, Credit Accounts Receivable $500.

A significant limitation of the direct write-off method is its non-compliance with Generally Accepted Accounting Principles (GAAP) for accrual basis accounting. This method violates the matching principle because the bad debt expense is recorded when an account becomes uncollectible, which may be in a different period than when the related revenue was earned. This can distort financial statements by misrepresenting profitability and the true value of accounts receivable.

Allowance Method

The allowance method is the preferred approach under GAAP for businesses that extend credit, as it adheres to the matching principle. This method estimates uncollectible accounts at the end of each accounting period and records the expense in the same period as the related sales revenue. It establishes an “Allowance for Doubtful Accounts,” a contra-asset account that reduces total accounts receivable to their estimated net realizable value on the balance sheet.

Two primary approaches are used to estimate bad debt under the allowance method: the percentage of sales method and the aging of accounts receivable method. The percentage of sales method, also known as the income statement approach, estimates bad debt based on a percentage of credit sales for the period. For example, if a company has $1,000,000 in credit sales and estimates 1% will be uncollectible, the estimated bad debt expense is $10,000.

The journal entry to record this estimate debits Bad Debt Expense and credits Allowance for Doubtful Accounts. In the example above: Debit Bad Debt Expense $10,000; Credit Allowance for Doubtful Accounts $10,000. This entry recognizes the expense in the current period, aligning it with the sales revenue.

The aging of accounts receivable method, or the balance sheet approach, estimates the uncollectible amount by categorizing outstanding receivables by their age. Older receivables are assigned a higher percentage of uncollectibility. For instance, accounts 1-30 days past due might have a 2% uncollectible rate, while those over 90 days past due might have a 50% rate. The sum of these estimated uncollectible amounts for each category represents the desired ending balance in the Allowance for Doubtful Accounts.

The journal entry to record bad debt expense using the aging method adjusts the Allowance for Doubtful Accounts to reach the calculated desired balance. If the desired balance is $15,000 and the allowance account currently has a $3,000 credit balance, the entry would be for $12,000: Debit Bad Debt Expense $12,000; Credit Allowance for Doubtful Accounts $12,000. This brings the allowance account to the target amount.

When a specific customer’s account is later determined to be uncollectible, it is written off against the Allowance for Doubtful Accounts. This journal entry debits Allowance for Doubtful Accounts and credits Accounts Receivable. For example, if a $300 account is written off: Debit Allowance for Doubtful Accounts $300; Credit Accounts Receivable $300. This write-off does not affect Bad Debt Expense directly, as the expense was already recognized when the estimate was made.

If a previously written-off account is subsequently collected, a two-step process is followed. First, the account is reinstated by debiting Accounts Receivable and crediting Allowance for Doubtful Accounts. This reverses the original write-off. Second, the cash collection is recorded by debiting Cash and crediting Accounts Receivable. For instance, if the $300 account is recovered, the entries would be: Debit Accounts Receivable $300, Credit Allowance for Doubtful Accounts $300; then Debit Cash $300, Credit Accounts Receivable $300.