If you operate the business on credit—i.e. offer your customers payment terms like Net 30 and Net 15—sooner or later you’ll run into a customer who either can’t or won’t pay you. When money your customers owe you becomes uncollectible like this, we call that bad debt (or a doubtful debt).
When you ultimately give up on collecting a debt (normally it’ll be in the form of a receivable
account) and choose to eliminate it from your company’s accounts, you need to do so by recording an expense. We call this a bad debt expense.
Here, we’ll explore exactly what bad debt expenses are, where to find bad debt expense on your income statements, how to calculate your bad debts, and how to record bad debt expenses correctly in your bookkeeping.
Table of Contents
- 1 What is a Bad Debt Expense?
- 2 How to Calculate Bad Debt Expenses?
- 3 How to Take Bad Debts Off Your Business Tax Return?
- 4 How to Estimate Bad Debt Expense?
- 5 Allowance for Doubtful Accounts and Bad Debt Expenses
- 6 Importance of Bad Debt Expense
What is a Bad Debt Expense?
A bad debt expense is a financial transaction that you record in your books to account for any bad debts your business has given up on collecting.
You only must record bad debt expenses if you use accrual accounting principles. Bad debts
are still bad if you use cash accounting principles, but since you never recorded the bad debt as revenue in the first place, there’s no income to “reverse” using a bad debt expense transaction.
Bad debt expenses make certain that your books show what’s actually going on in your business and that your business’ net income doesn’t look higher than it actually is. Correctly recording bad debt expenses is important if you want to decrease your tax bill and not pay taxes on profits you never earned.
How to Calculate Bad Debt Expenses?
There are two approaches to calculate your business’ bad debts: by directly writing off your accounts receivable, and through the allowance method.
- Direct write-off method
The direct write-off method includes writing off a bad debt expense directly against the corresponding receivable account. Hence, under the direct write-off method, a specific dollar amount from a customer account will be recorded off as a bad debt expense.
However, the direct write-off method can lead to misstating the income between reporting periods if the bad debt journal entry appeared in a different period from the sales entry. For such a reason, it is only allowed when writing off immaterial amounts. The journal entry for the direct write-off method is a debit to bad debt expense and a credit to accounts receivable.
|Bad Debt Expense||XX|
- Allowance method
The allowance method estimates bad debt expense at the end of the fiscal year, creating a reserve account known as allowance for doubtful accounts. Like its name, the allowance for doubtful accounts reports a projection of receivables that are “doubtful” to be paid.
Compared to the direct write-off method, the allowance method is only an estimation of money that won’t be collected and is dependent on the entire accounts receivable account. The amount of money written off with the allowance method is estimated through the accounts receivable aging method or the percentage of sales method. An example of an allowance method journal entry can be found below.
Entry 1: The amount of bad debt is estimated using the accounts receivable aging method or percentage of sales method and is recorded as follows:
|Bad Debt Expense||XX|
|Allowance for Doubtful Accounts||XX|
Entry 2: When a specific receivables account is considered to be uncollectible, allowance for doubtful accounts is debited, and accounts receivable is credited.
|Allowance for Doubtful Accounts||XX|
Most businesses will establish their allowance for bad debts using some form of the percentage of bad debt formula.
What is the Percentage of Bad Debt Formula?
Because you set it up ahead of time, your allowance for bad debts will always be an estimate. Estimating your bad debts usually involves some form of the percentage of bad debt formula, which is just your past bad debts divided by your past credit sales.
The formula is:
Percentage of bad debt = Total bad debts / Total credit sales
Let’s assume you’ve been in business for a year, and that of the total $300,000 in credit sales you made in your first year, $20,000 ended up uncollectable. You want to establish an allowance for bad debts to consider these bad debts ahead of time. How big should the allowance be?
First, you’d find out your percentage of bad debts:
Percentage of bad debt = $20,000 / $300,000
Percentage of bad debt = 6.67%
If 6.67% seems like a fair estimate for future uncollectible accounts, you would then make an allowance for bad debts equal to 6.67% of this year’s estimated credit sales.
If you have $50,000 of credit sales in January, on January 30th you might record an adjusting entry to your Allowance for Bad Debts account for $3,335.
But this isn’t always a trustworthy method for forecasting future bad debts, particularly if you haven’t been in business very long or if one big bad debt is falsifying your percentage of bad debt.
How to Take Bad Debts Off Your Business Tax Return?
Bear in mind, you will be required to run your business on the accrual accounting method to be qualified to take deductions for bad debt losses.
There are measures you must take to write off bad debts at the end of a year. You must wait until the end of the year, in case someone pays.
- Prepare accounts receivable aging report. An account receivable aging report displays all the money owed to you by all customers, how much is owed, and how long the amount has been outstanding.
- Add up all bad debts for the year. You will need a list of all customers who have not paid during the year. You should only make this decision at the end of the year, and only if you have made every effort to collect the money owed to your business.
- Incorporate the bad debt total on your business tax return. If you file your business taxes on Schedule C, you can subtract the amount of all the bad debts. Each type of business tax return has a place to enter bad debt expenses.
How to Estimate Bad Debt Expense?
The amount of bad debt expense can be estimated using the accounts receivable aging method or the percentage sales method.
1. Accounts Receivable Aging Method
The accounts receivable aging method groups receivable accounts depending on age and allocate a percentage based on the probability to collect. The percentages will be estimates based on a company’s previous history of the collection.
The estimated percentages are then multiplied by the total amount of receivables in that date range and added together to calculate the amount of bad debt expense. The table below shows how a company would utilize the accounts receivable aging method to estimate bad debts.
|Age of Receivable||<30 days||30-60 days||61-90 days||91+ days|
|% Not Collected||1%||4%||10%||30%|
|Estimation of Uncollected Amount||$100||$80||$500||$900|
|Total Bad Debts||&1,580|
2. Percentage of Sales Method
The percentage of sales method basically takes the total sales for the period and multiplies that number by a percentage. Once again, the percentage is an estimate dependent on the company’s previous ability to collect receivables.
For instance, if a company with sales of $2,000,000 estimates that 2% of sales will be uncollectible, their bad debt expense would be $40,000 ($2,000,000 * 0.02).
Assume a roofing business that agrees to replace a customer’s roof for $10,000 on credit. The project is completed; nevertheless, during the time between the start of the project and its completion, the customer is unable to meet their financial obligation.
The original journal entry for the transaction would include a debit to accounts receivable, and a credit to sales revenue. Once the company becomes mindful that the customer will not be able to pay any of the $10,000, the change needs to be shown in the financial statements.
Therefore, the business would credit accounts receivable of $10,000 and debit bad debt expense of $10,000. If the customer is able to pay a partial amount of the balance (say $5,000), it will debit cash of $5,000, debit bad debt expense of $5,000, and credit accounts receivable of $10,000.
|Example Situation A|
|Bad Debt Expense||$10,000|
|Example Situation B|
|Bad Debt Expense||$5,000|
Allowance for Doubtful Accounts and Bad Debt Expenses
An allowance for doubtful accounts is deemed as a “contra asset,” because it lowers the amount of an asset, in this case the accounts receivable. The allowance, every so often called a bad debt reserve, signifies management’s estimate of the amount of accounts receivable that will not be paid by customers. If real experience differs, then management adjusts its estimation procedure to bring the reserve more into orientation with actual results.
In accrual-basis accounting, recording the allowance for doubtful accounts at the same time as the sale improves the precision of financial reports. The expected bad debt expense is accurately matched against the related sale, thus providing a more correct view of revenue and expenses for a particular period of time. Moreover, this accounting process inhibits the large swings in operating results when uncollectible accounts are written off directly as bad debt expenses.
Units should take into account allowance for doubtful accounts when they are often providing goods or services “on credit” and have familiarity with the collectability of those accounts. The following entry should be made according to your revenue and reporting cycles (recording the expense in the same reporting period as the revenue is earned), but at a minimum, annually.
DR Bad Debt Expense
CR Allowance for Doubtful Accounts
|Object Code||Object Code Name||Description|
|6330||Bad Debt Expense||Write off of uncollectible Accounts Receivable.
Use: Use with approval from the Division of Financial Affairs only.
|1250||Allowance for Doubtful Accts||Allowance for Doubtful Accounts is a contra current asset object code associated with A/R. When the allowance object code is used, the unit is anticipating that some accounts will be uncollectible in advance of knowing the specific amount.
Use: Units billing sales to external customers where the possibility of default exists. The allowance normalizes fund balance activity.
When it is decided that an account cannot be collected, the receivable balance should be written off. When the unit holds an allowance for doubtful accounts, the write-off lowers the outstanding accounts receivable, and is charged against the allowance – do not record bad debt expense again!
DR Allowance for Doubtful Accounts
CR Accounts Receivable
Example of Bad Debts Expense and Allowance for Doubtful Accounts
To demonstrate, let’s suppose that on December 31 a company had $100,000 in Accounts Receivable and its balance in Allowance for Doubtful Accounts was a credit balance of $3,000. Due to this, the December 31 balance sheet will be reporting that $97,000 will be turning to cash. During the first 30 days of January the company does not have any other data on bad accounts receivable. Though, on January 31 the company discovers that an additional $1,000 of its accounts receivable may not be collected. Hence, on January 31 the company will make an adjusting entry to debit Bad Debts Expense for $1,000 and to credit Allowance for Doubtful Accounts for $1,000. After this entry is recorded, the company’s income statement for the month of January will report Bad Debts Expense of $1,000 and its January 31 balance sheet will report a credit balance in Allowance for Doubtful Accounts in the amount of $4,000.
Importance of Bad Debt Expense
Every fiscal year or quarter, companies prepare financial statements. The financial statements are viewed by investors and potential investors, and they are required to be reliable and must possess integrity. Investors are placing their hard-earned money into the company and if companies are not delivering truthful financial statements, it implies that they are cheating investors into placing money into their company based on misleading information.
Bad debt expense is something that must be recorded and accounted for every time a company makes its financial statements. When a company chooses to leave it out, they exaggerate their assets and they could even overstate their net income.
Bad debt expense also facilitates companies to identify which customers default on payments more regularly than others. If a company does choose to use a loyalty system or a credibility system, they can use the information from the bad debt accounts to figure out which customers are creditworthy and offer them discounts for their timely payments.