How to Calculate Bad Debt Expense: 10 Best Practices for Businesses

If using the direct write-off method, the entry to write off an uncollectible account is a debit to “Bad Debt Expense” and a credit directly to “Accounts Receivable” for the specific customer. As an example of the allowance method, ABC International records $1,000,000 of credit sales in the most recent month. Historically, ABC usually experiences a bad debt percentage of 1%, so it records a bad debt expense of $10,000 with a debit to bad debt expense and a credit to the allowance for doubtful accounts. Maintaining accurate records of accounts receivable is essential for calculating bad debt expense. Implement robust accounting systems to track invoices, payments, and outstanding balances.

What Is Bad Debt Expense & How Is It Accounted For?

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, or BDE is an accounting entry that lists the dollar amount of receivables your company does not expect to collect. Accountants record bad debt as an expense under Sales, General, and Administrative expenses (SG&A) on the income statement.

• Each category is assigned a different percentage likelihood of becoming uncollectible, reflecting the increased risk of non-payment over time.
• Factors such as the duration of delinquency (e.g., 90+ days overdue), borrower payment history, outstanding balance, and likelihood of recovery should guide this decision.
• These accounts arise from credit sales where customers have not, or will not, fulfill their payment obligations.
• The specific amount is determined based on the company’s past records and individual circumstances.
• On the balance sheet, bad debt expense is accounted for under accounts receivable through an adjustment called the Allowance for Doubtful Accounts.

Why do bad debts happen?

This expense is recorded in the financial statements to reflect potential losses from uncollectible accounts. This process involves removing the account from the accounts receivable balance and recording it as a bad debt expense. Writing off uncollectible accounts affects both the income statement, where it is recorded as an expense, and the balance sheet, where it reduces the total receivables.

One of the most effective ways to reduce bad debt is by tightening credit policies. This is called extending credit, and it helps attract more bad debt expense buyers and grow sales. In accrual accounting, companies recognize revenue before cash arrives in their accounts and must record expenses in the same accounting period the revenue originated. By contrast, if you’re using the cash accounting method, you’ll never need to concern yourself with bad debt expense since you’d only record revenue when you receive cash. For example, if the bad debt rate is 1%, 1% of the current credit sales would be allocated to the bad debt allowance account.

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The percentage of sales method calculates bad debt expense based on a fixed percentage of total credit sales. This method is straightforward and widely used, particularly suitable for businesses with consistent and predictable sales patterns. It simplifies the estimation process by applying a historical bad debt percentage to current sales figures. Bad debt directly influences a company’s financial health by impacting its net income. In accounting, bad debt is treated as an expense because it represents a loss of revenue.

Direct write-off method

• By implementing strict credit policies, improving collection efforts, and utilizing third-party collections when necessary, businesses can reduce the impact of bad debt and maintain financial stability.
• Others simply refuse to settle their invoices due to financial struggles or disputes over services or products.
• Bad debt can be reported on the financial statements using the direct write-off method or the allowance method.
• Bad debt is the expense account, which will show in the operating expense of the income statement.
• Whether you’re a business owner, an accounting student, or someone interested in financial management, understanding bad debt expense is essential.

This proactive financial planning helps businesses manage the impact of bad debts on their cash flow and profitability. Setting aside a reserve for bad debts is a prudent approach to financial management, safeguarding against unexpected revenue losses. Recording these losses helps match revenue and expenses in the right accounting period, keeping your financial statements accurate. When a specific customer account is identified as uncollectible and must be written off, the journal entry depends on the method previously used. Under the allowance method, the write-off involves a debit to “Allowance for Doubtful Accounts” and a credit to “Accounts Receivable” for the specific customer.

Percentage of Receivables

For example, based on the history data, Company XYZ estimates that 2% of their accounts receivable will be uncollectible. On 01 Jan 202X, the company makes selling on the credit of $ 50,000 from many customers. Accounts receivable present in the balance sheet is the net amount, which remains after deducting the allowance for the doubtful account. The materiality principle dictates that all significant information should be reported in financial statements. When applied to bad debt, this principle means that only the amounts that could influence the decision-making process of users of the financial statements should be recorded.

Revenue Recognition

Yes, if a customer pays after their debt has been written off, the amount is considered a bad debt recovery. This reserve is called the Allowance for Doubtful Accounts, and it’s reported on the balance sheet. By setting aside a portion of revenue for potential bad debts, companies follow the matching principle, ensuring that expenses are recognized in the same period as the related revenue. The impact of bad debt expense extends directly to a company’s primary financial statements, providing stakeholders with insights into the quality of its receivables and overall profitability. How bad debt is presented reflects the accounting methods used and adheres to reporting standards.

This allowance is an estimate based on past experiences with bad debts and current market conditions. It serves as a buffer against potential financial losses and is essential for accurately presenting a company’s financial health. Bad debt expense is a financial term used to describe the amount of credit sales that a company realistically anticipates will not be paid by customers.

Send reminders for outstanding invoices as the due date draws nearer and after the payments are due. This can help reduce the risk of bad debt expenses over time and may improve your on-time payments. To use the allowance method, record bad debts as a contra-asset account (an account that has a zero or negative balance) on your balance sheet. In this case, you would debit the bad debt expense and credit your allowance for bad debts. Therefore, the business would credit accounts receivable of $10,000 and debit bad debt expense of $10,000.

So, if you want your business to fully understand its actual financial standing — as opposed to what it might look like in a best-case scenario — tracking and managing these bad debts is critical. In this article, we’ll explore bad debt expense, why it happens, and how to manage it effectively. Generally, the longer an invoice remains unpaid, the lower the likelihood of it being settled.

Bad debt expense is an inevitable challenge for many businesses, especially those offering credit terms. When customers fail to pay, it not only impacts your revenue but also distorts your financial projections. Understanding bad debt expense—how to calculate it, track it, and minimize its impact—is key to protecting your cash flow.