Bad Debt Expense Definition + Journal Entry Examples


how to calculate the bad debt expense

It is important to note, however, that the recorded allowance does not represent the actual amount but is instead a “best estimate”. Given the prevalence of paying on credit in the modern economy, such instances have become inevitable, although improved collection policies can reduce the amount of write-offs and write-downs. Now let’s say that a few weeks later, one of your customers tells you that they simply won’t be able to come up with $200 they owe you, and you want to write off their $200 account receivable. These steps can aid in both securing collections and minimizing the time and resources you need to manage receivables. In 2022, SMEs (small and medium enterprises) in the UK wrote off £5.8 billion in bad debt alone! When you’re a Pro, you’re able to pick up tax filing, consultation, and bookkeeping jobs on our platform while maintaining your flexibility.

Bad Debt Expense Definition and Methods for Estimating

A bad debt expense is a portion of accounts receivable that your business assumes you won’t ever collect. Also called doubtful debts, bad debt expenses are recorded as a negative transaction on your business’s financial statements. If your small business accepts credit sales, you run the risk of encountering something called a “bad debt expense.” Bad debt expenses are outstanding accounts that, after some time going unpaid, are deemed uncollectible. If 6.67% sounds like a reasonable estimate for future uncollectible accounts, you would then create an allowance for bad debts equal to 6.67% of this year’s projected credit sales. The percentage of sales method is an income statement approach, in which bad debt expense shows a direct relationship in percentage to the sales revenue that the company made.

  1. Usually, the longer a receivable is past due, the more likely that it will be uncollectible.
  2. 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.
  3. Bad debts are still bad if you use cash accounting principles, but because you never recorded the bad debt as revenue in the first place, there’s no income to “reverse” using a bad debt expense transaction.
  4. However, the entries to record this bad debt expense may be spread throughout a set of financial statements.
  5. Understanding and mitigating these risks is essential for effective accounts receivable management and financial stability.

Is Bad Debt an Expense or a Loss?

Using the direct write-off method, uncollectible accounts are written off directly to expense as they become uncollectible. On the other hand, the allowance method accrues an estimate that gets continually revised. Bad debt expenses make sure that your books reflect what’s actually happening in your business and that your business’ net income doesn’t appear higher than it actually is.

how to calculate the bad debt expense

Using the Allowance Method: An In-Depth Look

how to calculate the bad debt expense

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. Companies periodically adjust their allowance for doubtful accounts to reflect the changing risk landscape and economic environment. This adjustment is critical for accurate financial reporting and involves revising the estimated uncollectible amount based on current data and trends.

Ageing of accounts receivable formula example

In this example, Company B has an average monthly sales of £10,000 and outstanding invoices of £2,500. Tickmark, Inc. and its affiliates do not provide legal, tax or accounting advice. The information provided on this website does not, and is not intended to, constitute legal, tax or accounting advice or recommendations. All information prepared on this site is for informational purposes only, and should not be relied on for legal, tax or accounting advice. You should consult your own legal, tax or accounting advisors before engaging in any transaction. The content on this website is provided “as is;” no representations are made that the content is error-free.

Because the company may not actually receive all accounts receivable amounts, Accounting rules requires 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 because, even though revenue had been booked, it never materialized into cash. Recording uncollectible debts will help keep your books balanced and give you a more accurate view of your accounts receivable balance, net income, and cash flow. In that case, you simply record a bad debt expense transaction in your general ledger equal to the value of the account receivable (see below for how to make a bad debt expense journal entry). 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.

Use your financial statements not just to identify the impact of bad debt, but also to proactively analyze trends in your receivables function. Companies should regularly employ key financial ratios and metrics to gauge the health of their receivables function. Metrics such as Days Sales Outstanding (DSO), Receivables Turnover Ratio and other ratios offer a clear view of how effectively a business is managing its credit and collections processes. Monitoring these indicators helps in optimizing cash flows and enhancing financial stability.

Under this approach, businesses find the estimated value of bad debts by calculating bad debts as a percentage of the accounts receivable balance. Bad debt expense is account receivables that are no longer collectible due to customers’ inability to fulfill financial obligations. There are two distinct ways of calculating how variance analysis can improve financial results bad debt expenses – tBad debt expense is account receivables that are no longer collectible due to customers’ inability to fulfill financial obligations. There are two distinct ways of calculating bad debt expenses – the direct write-off method and the allowance method.he direct write-off method and the allowance method.

Credit transactions carry the inherent risk of non-payment, which businesses must account for when extending credit to customers. In accounting, the bad debt expense emerges from customers that purchased a product or service using credit as the form of payment, rather than cash, yet are unable to fulfill their obligations to eventually pay in cash. If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $2,400 is recorded in the second period in bad debt expense.

While some might view it as overly conservative, it reduces the chance of steep losses that were unexpected. QuickBooks has a suite of customizable solutions to help your business streamline accounting. From insightful reporting to budgeting help and automated invoice processing, QuickBooks can help you get back to the daily tasks you love doing for your small business. Bad debt expenses are classified as operating costs, and you can usually find them on your business’ income statement under selling, general & administrative costs (SG&A). While you can’t control the solvency of your customers—though you can implement credit checks—you can take proactive steps to keep collections efficiently moving. Additionally, overwhelmed accounting teams may struggle to keep up with the volume of collections tasks, leading to further delays and missed opportunities to recover outstanding balances.

Bad debt expense is recorded as a contra-asset account on the balance sheet, which reduces the total value of accounts receivable. This adjustment ensures that the balance sheet reflects a more realistic view of the financial assets and their expected economic benefits. It highlights the company’s proper financial position by acknowledging potential losses in receivables. This article covers how to calculate your bad debt expense formula, examples of its use, what it means, and how you can use it to protect your business.

Knowing the right forms and documents to claim each credit and deduction is daunting. Thomas J Catalano is a CFP and Registered Investment Adviser with the state of South Carolina, where he launched his own financial advisory firm in 2018. Thomas’ experience gives him expertise in a variety of areas including investments, retirement, insurance, and financial planning.


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