Methods for How to Calculate Bad Debts

Businesses often extend credit to customers, which introduces a risk: some may not pay their outstanding balances. These uncollectible amounts are known as bad debts. Bad debt represents a financial loss and requires proper accounting to accurately reflect financial health. Recognizing and accounting for bad debts is important for financial reporting, ensuring a company’s financial statements present a realistic picture of its assets and income.

Direct Write-Off Method

The direct write-off method recognizes bad debt expense only when a specific account receivable is definitively identified as uncollectible. No estimation of uncollectible accounts is made in advance. When a customer will not pay, such as due to bankruptcy or prolonged non-payment, the specific account is removed from the books.

The uncollectible amount is debited to Bad Debts Expense and credited to Accounts Receivable. For example, if a $500 invoice is uncollectible, Bad Debts Expense increases by $500, and Accounts Receivable decreases by $500.

This method is simpler as it avoids estimations. However, it is generally not permitted under accrual accounting principles like GAAP for most businesses. This is because it records the expense in a period often different from when the related revenue was recognized, violating the matching principle. It may be used by very small businesses with immaterial bad debt amounts or for federal income tax purposes.

Allowance Method: Percentage of Sales

The allowance method estimates bad debts before specific accounts are identified as uncollectible, addressing the matching principle. This aims to record bad debt expense in the same period as the sales that generated the receivables. The percentage of sales method, a common technique, estimates bad debt expense as a percentage of a company’s total credit sales for a given period.

Businesses determine this percentage based on historical data of uncollectible credit sales. If past experience shows 1% of credit sales become uncollectible, that rate is applied to current credit sales. For example, $100,000 in credit sales with a 1% estimate yields $1,000 in bad debt expense. This amount is recorded by debiting Bad Debt Expense and crediting Allowance for Doubtful Accounts, a contra-asset account. This method focuses on the income statement, ensuring the expense is recognized concurrently with the revenue it helped generate.

Allowance Method: Aging of Receivables

The aging of receivables method is another approach within the allowance method for estimating bad debts. This method recognizes that the longer an account receivable remains outstanding, the less likely it is to be collected. Businesses categorize outstanding accounts receivable by age, such as 1-30 days, 31-60 days, 61-90 days, and over 90 days past due. This categorization is presented in an aging schedule.

After categorizing, different uncollectibility percentages are applied to each age category. These percentages are higher for older receivables, reflecting increased risk. For example, 1% might apply to current receivables, while 50% or more applies to accounts over 90 days past due. The estimated uncollectible amount for each category is calculated by multiplying the total receivables by its assigned percentage. Summing these amounts provides the total estimated uncollectible amount for all receivables.

This total represents the desired ending balance in the Allowance for Doubtful Accounts. To determine the bad debt expense for the current period, the existing Allowance for Doubtful Accounts balance is compared to this desired ending balance. The bad debt expense recorded is the amount needed to adjust the allowance account to its calculated level. This method focuses on the balance sheet, ensuring accounts receivable are reported at their estimated net realizable value.

Recording Calculated Bad Debts

Once bad debt amounts are calculated, they are recorded in a company’s financial records through journal entries. The recording process differs based on the method used for calculation.

For businesses using the direct write-off method, when an account is uncollectible, a direct journal entry is made. This entry debits “Bad Debts Expense” and credits “Accounts Receivable.” This reduces the accounts receivable balance and recognizes the loss. If a previously written-off debt is later collected, the initial write-off entry is reversed by debiting Accounts Receivable and crediting Bad Debts Expense. Then, record the cash collection by debiting Cash and crediting Accounts Receivable.

For companies using the allowance method, two types of entries occur. First, to record the estimated bad debt expense for a period, a journal entry debits “Bad Debts Expense” and credits “Allowance for Doubtful Accounts.” Bad Debts Expense appears on the income statement, reducing net income, while Allowance for Doubtful Accounts is a contra-asset account on the balance sheet, reducing the reported value of Accounts Receivable.

Second, when a specific customer account is identified as uncollectible, a separate entry debits “Allowance for Doubtful Accounts” and credits “Accounts Receivable.” This write-off does not affect Bad Debts Expense or net income, as the expense was already estimated. If a previously written-off account is later collected, reinstate the original write-off by debiting Accounts Receivable and crediting Allowance for Doubtful Accounts. Then, record the cash collection by debiting Cash and crediting Accounts Receivable.