When Is Bad Debt Expense Recorded in Accounting?

When businesses offer goods or services on credit, some customers may not pay their invoices. This risk leads to bad debt expense, an accounting adjustment reflecting the portion of accounts receivable expected to be uncollectible. Accurate bad debt accounting presents financial health by matching revenues with expenses. Understanding its recognition is fundamental to financial reporting.

The Concept of Bad Debt Expense

Bad debt expense arises from credit sales when customers delay payment. It represents the estimated or actual loss incurred when customers cannot pay their debts. Businesses extend credit to facilitate sales, carrying non-payment risk.

Bad debt expense recognition aligns with the matching principle, recording expenses in the same period as revenues. For instance, if a January sale’s payment is uncollectible, the bad debt expense should be recognized in January or the sale period. This aligns revenues and expenses for accurate profitability.

Recording Bad Debt with the Direct Write-Off Method

The direct write-off method records bad debt expense only when a customer account is identified as uncollectible. It is not estimated in advance. Instead, a journal entry debits Bad Debt Expense and credits Accounts Receivable when deemed worthless. For example, a company writes off the balance when a customer files for bankruptcy.

This method is simpler, requiring no estimates. However, it often misaligns with the matching principle if the credit sale occurred in a prior accounting period. GAAP generally does not permit the direct write-off method due to its failure to match revenues and expenses. Smaller businesses or those using it for income tax purposes often utilize it, as the Internal Revenue Service (IRS) allows deductions for bad debts when actually worthless.

Recording Bad Debt with the Allowance Method

The allowance method is the preferred GAAP approach for bad debt expense, adhering to the matching principle. Companies estimate uncollectible accounts and record bad debt expense before accounts are identified as worthless. Estimation usually occurs at the end of an accounting period (monthly, quarterly, or annually). The expense is recorded by debiting Bad Debt Expense and crediting Allowance for Doubtful Accounts.

Allowance for Doubtful Accounts is a contra-asset account, reducing Accounts Receivable on the balance sheet. Estimation uses techniques like the percentage of sales method, estimating a fixed percentage of current credit sales as uncollectible. The aging of receivables method categorizes invoices by age, applying different uncollectibility percentages (e.g., 90-day past due invoices have a higher estimated uncollectibility rate than 30-day ones).

Uncollectible accounts are written off against Allowance for Doubtful Accounts, not Bad Debt Expense. For example, an uncollectible $500 invoice leads to a debit to Allowance for Doubtful Accounts and a credit to Accounts Receivable. This write-off does not affect Bad Debt Expense or net income in the current period, as the expense was recognized when initially estimated.

Key Indicators for Recognizing Uncollectible Accounts

Several indicators signal an uncollectible account, prompting bad debt expense recognition or write-off. One indicator is customer bankruptcy, which legally limits debt collection. Another sign is a customer ceasing operations or going out of business, leaving no means for payment. These situations make collection highly improbable.

Prolonged non-payment, despite collection attempts, indicates uncollectibility. If an invoice remains outstanding for an extended period (e.g., 120 days past due), collection becomes increasingly unlikely. A customer’s explicit refusal to pay or dispute of charges without valid reason signifies an unrecoverable debt. These circumstances trigger bad debt accounting entries.