What is a bad debt expense?
Not all customers pay what they owe, but there’s a way of accounting for it
If you’re a business owner extending credit to customers, then you’ve likely had an experience with bad debt or will at some point in the future. A bad debt expense is the official accounting term used when you can’t collect a receivable. It may occur for myriad reasons, but you’re still responsible for reporting it correctly.
Let’s take a closer look at what a bad debt expense means from an accounting perspective, how to calculate it and where it gets reported in the income statement.
A bad debt expense occurs when a company extends credit to a customer but no longer expects to receive payment.
Jump to insightA company can experience a bad debt expense due to several reasons, such as a customer’s inability to pay due to bankruptcy.
Jump to insightCompanies can account for a bad debt expense in their accounts receivables by either using the direct write-off method or allowance method.
Jump to insightWhat is a bad debt expense?
A bad debt expense refers to the portion of sales revenue a company no longer expects to collect from its customers. You may also see it referred to as a doubtful debt. The customer may not provide payment for a variety of reasons, such as due to a lack of funds or a dispute about receiving poor service or products.
Bad debt expense is an important accounting provision needed so a company can accurately reflect the reality of customers defaulting on their payments. It’s an expense recorded on the income statement as a cost of doing business and must be included for accurate financial reporting and analysis. It’s also critical that it gets reported correctly because of the implications on the company’s tax bill.
» MORE: Good debt versus bad debt
Examples of a bad debt expense
One example of a bad debt expense is when a customer doesn’t pay their invoice. Evan Mann, a credit analyst with Gimme Credit, gave the following example: “Company A sells $100 of goods to Company B on credit. Company A ships the goods to Company B posting sales of $100 and an account receivable of $100. If the $100 account receivable from Company B is not paid within a specified timeframe it would become a bad debt expense.”
In addition to this example of a customer not paying within the agreed-upon terms, your company can experience a bad debt expense in other scenarios as well, including:
- Customer bankruptcy: If you work with a customer who declares bankruptcy, then you may realize the debt owed to your company will not be recovered.
- Write-offs: Companies may proactively write off debts that are deemed uncollectible based on past experience or specific circumstances.
- Doubtful accounts: Another scenario for a bad debt provision is if the account collection seems doubtful based on factors such as aging or customer financial instability.
» MORE: What is debt settlement?
How to calculate a bad debt expense
Calculating a bad debt expense can occur by two different methods: direct write-off or allowance.
Direct write-off
The direct write-off method recognizes a bad debt expense when a company can identify a specific account as uncollectible. Instead of estimating bad debts upfront, individual accounts are monitored. Once it’s clear an account can’t be collected, a specific debt is directly written off as bad debt expense.
The direct write-off method may be straightforward, but it can also recognize a bad debt expense in a different period (such as a previous quarter) from when the related revenue was recorded. Because of this potential timing difference, it's typically used for smaller businesses or when the bad debts are infrequent.
Keep in mind the IRS states you can only write off a bad debt if “you’ve taken reasonable steps to collect the debt.”
Allowance
Another calculation method is referred to as the allowance method. With this calculation, the expenses must be recognized in the same time period as the revenue they helped generate. However, a company estimates the amount of uncollectible accounts receivable upfront, creating an allowance for accounts which the company predicts might become uncollectible.
A company can estimate the allowance based on historical data, industry norms, economic conditions or the company's previous experience with bad debts. The estimated amount is then recorded as a bad debt expense on the income statement, and the corresponding allowance for doubtful accounts is set up as a contra-asset on the balance sheet. When specific accounts finally come up as uncollectible, they are written off against this allowance.
Percentage of bad debt formula
If your company uses the allowance method, then it will need to estimate the amount of bad debt expense for a specific accounting period, which you can do using the percentage of the bad debt formula.
The bad debt formula is:Percentage of bad debt = (Total bad debts / Total credit sales) x 100
Total bad debts means the amount a company expects will become uncollectible during the accounting period. Total credit sales refers to the total amount of sales made on credit during the accounting period. It includes sales revenue generated from the transactions where your customers were allowed to purchase goods or services on credit terms versus paying upfront.
Reporting a bad debt expense
Recording the bad debt expense as a journal entry is the same, regardless of whether your company uses the direct write-off or allowance method. A company should report a bad debt expense on its income statement.
A bad debt expense typically appears within the operating expenses section, under the category "Selling, General and Administrative Expenses" or as a separate line item. “Bad debt is generally reported as an offset to accounts receivable,” added Mann, which means it’s a contra asset.
FAQ
Is bad debt an expense or a loss?
A bad debt expense can be classified as an expense because it gets listed in the “Selling, General and Administrative Expenses” category in income statements. It’s the result of a loss in income, but it falls under the expense classification.
How can you prevent a bad debt expense?
You can implement a few protocols that may help reduce bad debt expenses, including outlining your credit policy to customers, charging late fees or interest or setting up an automatic payment option. You can also set up a rewards system for customers who pay early or on time.
What factors should you consider when estimating a bad debt expense?
If your company uses the allowance method, then it’ll need to estimate bad debt expenses. Several factors can impact this estimation, including past collection experiences, current economic conditions, industry norms, the customer’s credit profile and the aging of accounts receivable. Your company's own credit policies and collection efforts can also have an impact on how much you estimate.
Bottom line
If you’re a company that extends credit to customers, then at some point you will likely face a bad debt expense. You can either account for it using the direct write-off method, which is more common among smaller companies, or the allowance method, which lets you estimate a percentage of bad debt expenses. No matter how your company accounts for it, a journal entry must be made for accurate reporting.
Article sources
ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
- IRS, “Topic no. 453, Bad debt deduction.” Accessed May 8, 2024.
- Bench, “Bad Debt Expense: Definition and How to Calculate It.” Accessed May 8, 2024.
- Let’s Ledger, “Throw Out the Bad Debt Expense.” Accessed May 8, 2024.
- Cornell University, “Allowance for Doubtful Accounts and Bad Debt Expenses.” Accessed May 8, 2024.
