What Is a Bad Debt Expense?
Let me explain bad debt expense directly: it's what you recognize when a receivable turns uncollectible because a customer can't pay up, often due to bankruptcy or financial woes. If you're a company extending credit, you report this as an allowance for doubtful accounts on your balance sheet—essentially a provision for credit losses. This isn't optional; it's a reality of doing business on credit.
Understanding Bad Debt Expense
You need to grasp that bad debt expense is an inevitable cost when you sell on credit, given the inherent default risk. When you make a credit sale, you debit accounts receivable and credit revenue, but there's no certainty you'll collect. That's why accounting rules demand you estimate what might not come in and record it as a hit to net income—even if revenue was booked, the cash never arrives. I classify this as a sales and general administrative expense on the income statement, and it offsets accounts receivable on the balance sheet, though you can still chase the debt if things turn around.
How to Calculate Bad Debt Expense
There are two main ways to handle this calculation, and I'll walk you through them. First, the direct write-off method: you write off uncollectible accounts straight to expense as you identify them. It's simple, debiting bad debt expense and crediting accounts receivable, but it ignores the matching principle under GAAP because expenses might not align with the sales period.
Then there's the allowance method, which is more aligned with accrual accounting. You estimate anticipated losses and accrue them, creating a contra-asset account called allowance for doubtful accounts that nets against receivables. This way, you debit bad debt expense and credit the allowance, adjusting it over time based on your estimates. It's about preventing overstatement of income by factoring in expected delinquencies right away.
How to Estimate Bad Debt Expense
Estimating is key, and you can use statistical modeling like default probabilities, drawing from your historical data or industry stats. Percentages often rise with the age of the receivable to account for higher default risks.
Primary Estimation Methods
- Accounts Receivable Aging Method: Group your receivables by age, apply specific percentages to each group based on past experience, and sum up the uncollectible estimate. For instance, if you have $70,000 under 30 days (1% uncollectible) and $30,000 over 30 days (4% uncollectible), your allowance is $1,900, with adjustments in future periods.
- Percentage of Sales Method: Apply a flat percentage to your total net sales, rooted in historical bad debt rates. Say 3% on $100,000 sales means $3,000 in bad debt expense and allowance; it builds cumulatively across periods.
Example of Bad Debt Expense
Take Amazon's 2021 annual report as a real-world case. They reported $32.89 billion in net accounts receivable, but footnotes reveal a $1.1 billion allowance for doubtful accounts, meaning gross receivables were actually higher. The allowance stayed steady from 2020 to 2021, so bad debt expense wasn't material then, but a prior jump from $718 million in 2019 implied a significant expense to adjust. This shows how companies conservatively reduce reported assets to reflect potential losses.
Common Questions on Bad Debt Expense
You might wonder about examples: think of a bankrupt company unable to pay suppliers—those suppliers record bad debt expense for the loss. Is it an expense or a loss? Technically an expense, grouped with selling, general, and administrative costs, but it acts like a loss by cutting net income. Where does it show up? On the income statement under expenses, with the allowance contra to receivables on the balance sheet.
The Bottom Line
In the end, bad debt expense is just part of extending credit—expect some customers won't pay, so earmark a portion of sales or receivables as uncollectible. Use the allowance method to estimate and accrue it, reducing accounts receivable accordingly; the direct write-off is simpler but not GAAP-compliant for financial reporting. This keeps your statements realistic and compliant.
Other articles for you
Groupon is an online platform offering deals, coupons, and cashback to attract customers to businesses through group purchasing power.
Other current assets (OCA) are uncommon or insignificant liquid assets on a company's balance sheet that can be converted to cash within one year.
Demand deposits are bank accounts allowing immediate fund withdrawals without notice, ideal for everyday use but offering low interest.
Petty cash is a small cash reserve businesses use for minor expenses to avoid the hassle of checks or cards.
The operating ratio measures a company's efficiency by comparing its operating expenses and cost of goods sold to net sales.
Fixed income investments provide guaranteed returns through interest or dividends on debt securities like bonds, offering lower risk and stable income compared to stocks.
Accrued income refers to money earned by a company but not yet received or invoiced.
Force majeure clauses in contracts excuse parties from liability during unforeseeable catastrophic events that prevent fulfillment of obligations.
Price leadership is when a dominant firm sets prices that others in the industry must follow to maintain market share.
A T-account is a visual tool in double-entry bookkeeping that records debits on the left and credits on the right to track financial transactions.