What Is Bad Debt Expense in Accounting?

Businesses often extend credit to customers, allowing them to purchase goods or services now and pay later. This practice introduces a risk that some customers may not fulfill their payment obligations. When accounts become uncollectible, they are recognized as bad debts, representing revenue that will ultimately not be received. Accounting for these uncollectible amounts is necessary for financial reporting, ensuring a company’s financial statements accurately reflect its economic performance and position.

Understanding Bad Debt Expense

Bad debt expense is an operating expense businesses record to reflect the estimated portion of accounts receivable they do not expect to collect. This expense arises for various reasons, including customer insolvency, bankruptcy filings, or disputes over goods or services received. Recognizing bad debt prevents the overstatement of both revenue and assets, presenting an accurate financial picture.

The recognition of bad debt expense aligns with the accrual basis of accounting, where revenues and expenses are recorded when earned or incurred. It also adheres to the matching principle, requiring expenses to be recognized in the same period as the revenues they helped generate. For instance, if a credit sale occurs in one period, and payment is later unlikely, the bad debt expense should ideally be recognized in the same period as the original sale.

Recording bad debt expense ensures reported revenue is not inflated by sales that will never materialize into cash. It also prevents the overvaluation of accounts receivable on the balance sheet, as these assets are reduced to their net realizable value—the amount genuinely expected to be collected. This practice provides stakeholders with a more realistic view of the company’s financial health and its ability to convert credit sales into cash.

Methods for Accounting for Bad Debt

Businesses employ different methods to account for bad debt, each with distinct implications for financial reporting. The choice of method impacts when and how uncollectible accounts are recognized.

The direct write-off method recognizes bad debt only when a specific customer account is definitively identified as uncollectible and written off. For example, if a customer files for bankruptcy, their outstanding balance is immediately removed from accounts receivable and recorded as bad debt expense. While straightforward, this method generally does not comply with Generally Accepted Accounting Principles (GAAP) for material amounts because it violates the matching principle by delaying expense recognition.

In contrast, the allowance method is the preferred and GAAP-compliant approach. It estimates uncollectible accounts before specific ones are identified. This method establishes an “Allowance for Doubtful Accounts,” a contra-asset account that reduces total accounts receivable on the balance sheet. The allowance method ensures expenses are matched with revenues in the period sales occur, providing a more accurate measure of profitability.

Within the allowance method, two common approaches estimate bad debt expense. The percentage of sales method estimates bad debt based on a percentage of a company’s total credit sales for a period. For instance, if historical data suggests 2% of credit sales become uncollectible, then 2% of current period credit sales would be recorded as bad debt expense. This method focuses on the income statement, aiming to match expenses with current period revenues.

Another approach is the percentage of receivables method, often implemented through an aging of receivables schedule. This method categorizes outstanding accounts receivable by age (e.g., current, 1-30 days past due). Different uncollectibility percentages are applied to each age category, with older receivables typically assigned higher percentages. This approach provides a more precise estimate of the uncollectible portion of existing receivables, directly impacting the balance sheet by valuing accounts receivable at their net realizable amount.

Recording and Financial Statement Impact

The journal entries used to account for uncollectible receivables differ based on the method employed, affecting both the income statement and the balance sheet.

Under the allowance method, recognizing estimated bad debt expense involves a debit to “Bad Debt Expense” and a credit to “Allowance for Doubtful Accounts.” This entry increases the expense on the income statement and the contra-asset account on the balance sheet. When a specific account is later deemed uncollectible and written off, the entry debits “Allowance for Doubtful Accounts” and credits “Accounts Receivable,” removing the customer’s balance. This write-off does not impact bad debt expense or net income again, as the expense was already recognized.

In contrast, the direct write-off method records bad debt only when an account is specifically identified as uncollectible. The journal entry for this method is a debit to “Bad Debt Expense” and a credit to “Accounts Receivable.” This directly reduces both the expense and the asset at the time of write-off, though it is generally not GAAP-compliant for material amounts.

On the income statement, “Bad Debt Expense” is typically presented as an operating expense, reducing a company’s net income. This reduction directly reflects the cost of extending credit that will not be recovered, providing a clearer picture of profitability.

On the balance sheet, the “Allowance for Doubtful Accounts” is subtracted from the gross “Accounts Receivable” balance. The resulting figure, known as the net realizable value of accounts receivable, represents the amount of cash the company realistically expects to collect. This presentation provides users of financial statements with a more accurate valuation of the company’s liquid assets.