A bad debt expense is recognized when a receivable is no longer collectible because a customer is unable to fulfill their obligation to pay an outstanding debt due to bankruptcy or other financial problems. Companies that extend credit to their customers report bad debts as an allowance for doubtful accounts on the balance sheet, which is also known as a provision for credit losses.
Key Takeaways
- Bad debt expense is an unavoidable cost of doing business with customers on credit, carrying inherent default risk.
- The direct write-off method records the precise amount of uncollectible accounts as they are specifically identified.
- To comply with the matching principle, bad debt expense must be estimated using the allowance method in the same period in which the sale occurs.
- Two main methods to estimate an allowance for bad debts include the percentage of sales method and the accounts receivable aging method.
- The allowance method creates a contra asset allowance account that reduces the net amount of accounts receivable.
Grasping Bad Debt Expense
When a company makes a credit sale, it books a credit to revenue and a debit to an account receivable. The issue with this accounts receivable balance is that there is no guarantee the company will collect the payment. For various reasons, a company may be entitled to money for a credit sale but may never actually receive those funds.
Accounting rules require a company to estimate the amount it may not be able to collect. This amount must then be recorded as a reduction against net income, even though revenue was booked but never materialized into cash.
This estimated uncollectible amount is called a bad debt expense and is generally classified under sales and general administrative expenses. While part of an entry for bad debt expense resides on the balance sheet, bad debt expense is posted to the income statement. Recognizing bad debts likewise leads to an offsetting reduction to accounts receivable on the balance sheet, though businesses retain the right to collect funds should the circumstances change.
Calculating Bad Debt Expense
Two distinct methods are used to recognize bad debt expense: the direct write-off method and the allowance method.
Direct Write-Off Method
The direct write-off method captures the exact amount of uncollectible accounts, which is often used for tax purposes in the U.S. However, this method falls short of the matching principle essential in accrual accounting and generally accepted accounting principles (GAAP), as it records expenses in periods they can’t be predicted but occur after the related revenue.
Post a debit to ‘Bad Debt Expense’ and a credit to ‘Accounts Receivable’ when using the direct write-off method.
Allowance Method
The allowance method lets companies reflect anticipated losses in financial statements to avoid overstating potential income. A company will estimate how much of its current period’s receivables will default, based on previous experience. This requires debiting bad debts expense and crediting an allowance for doubtful accounts.
The allowance account, a contra-asset account, nets against total accounts receivable, modulating the receivables’ face value on the balance sheet.
Estimating Bad Debt Expense
Two main methods are used to estimate the uncollectible amounts:
Accounts Receivable Aging Method
Under the aging method, all outstanding accounts receivable are grouped by age, and specific percentages are applied to each group to reflect expected uncollectibility. For instance, a company with $70,000 of accounts receivable under 30 days and $30,000 over 30 days would calculate an allowance based on historic collectible experience—1% for the younger receivables and 4% for the older.
For a total bad debt expense of $1,900 (($70,000 * 1%) + ($30,000 * 4%)), any adjustments will account for changes in these estimates.
Percentage of Sales Method
This method straightly applies a flat percentage to total sales. If a company foresees 3% of net sales as non-collectible and records $100,000 net sales in a period, it prepares an allowance for doubtful accounts of $3,000 and simultaneously notes a $3,000 bad debt expense.
Continued adjustments ensure these provisions reflect reality, resulting in current period entries accurately matched with sales.
Example of Bad Debt Expense
Amazon’s 2021 annual report, although not explicitly stating bad debt expense, mentions accounts receivables and allowances in its financial statements notes. At the end of 2021, Amazon reported $32.89 billion in accounts receivable with a $1.1 billion allowance for doubtful accounts, showing conservatism in presenting net values.
The fluctuation in these allowances provides insight into actual bad debt expense impacts from one year to the next, essential for estimating future financial commitments.
Practical Instances of Bad Debt Expense
Consider a company undergoing bankruptcy, failing to meet its financial obligations. Such losses recognized by creditors typify bad debt expenses when debts remain unpaid after all attempts for collection.
Categorizing Bad Debt Expense
While technically classified as an expense, bad debt shares characteristics of a reduction in net income, often appearing alongside general and administrative costs while impacting profit margins.
Reporting Bad Debt Expense
Bad debt expense appears within the selling, general, and administrative expense section of the income statement. Allowance for doubtful accounts returns as a contra asset on the balance sheet, with bad debts directly reducing accounts receivable when written off.
The Bottom Line
Bad debt expense is a typical consideration for businesses extending credit. An estimated portion of sales or receivables often earmarked as bad debts involves allowance accounts to mitigate impacts on balance sheets, ensuring realistic reflection of collectible assets and income.
Related Terms: accounts receivable, allowance for doubtful accounts, contra-asset account, income statement, balance sheet.
References
- Amazon. “2021 Annual Report”.
