Bad debt expense is the amount of an account receivable that cannot be collected. The customer has chosen not to pay this amount, either due to financial difficulties or because there is a dispute over the underlying product or service sold to the customer. To some degree, the amount of this expense reflects the credit choices made by the seller when extending credit to customers. The amount of bad debt charged to expense is derived by one of two methods, which are:
Direct write off. When it becomes apparent that a specific customer invoice will not be paid, the amount of the invoice is charged directly to bad debt expense. This is a debit to the bad debt expense account and a credit to the accounts receivable account. Thus, the expense is directly linked to a specific invoice. This is not a reduction of sales, but rather an increase in expense.
Allowance method. When sales transactions are recorded, a related amount of bad debt expense is also recorded, on the theory that the approximate amount of bad debt can be determined based on historical outcomes. This is recorded as a debit to the bad debt expense account and a credit to the allowance for doubtful accounts. The actual elimination of unpaid accounts receivable is later accomplished by drawing down the amount in the allowance account. This is not a reduction of sales.
The bad debt expense calculation under the allowance method can be determined in a number of ways, such as:
Applying an overall bad debt percentage to all credit sales
Applying an increasingly large percentage to later time buckets in which accounts receivable are reported in the accounts receivable aging report
Based on a risk analysis of each customer
No matter which calculation method is used, it must be updated in each successive month to incorporate any changes in the underlying receivable information.
The direct write off method is not the most theoretically correct way to recognize bad debt expense, since the expense is recognized several months later than the revenue associated with the initial sale, thereby separating elements of the same transaction into different time periods. The more correct approach is the allowance method, since a portion of all sales is reserved against as soon as revenue is recognized. In the latter case, revenues and related expenses appear in the same time period, so one can see the full impact of all sales on profits within the same accounting period.
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. In the following months, an invoice for $2,000 is declared not collectible, so it is removed from the company's records with a debit of $2,000 to the allowance for doubtful accounts and a credit to accounts receivable.