Bad debt expense definition
/What is Bad Debt Expense?
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 noted below:
Direct write-off method. 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.
Direct Write-Off Method vs. Allowance Method
The direct write-off method and the allowance method are two accounting approaches for handling uncollectible accounts (bad debts). Here’s a detailed comparison of the two approaches:
GAAP compliance. The direct write-off method is not GAAP-compliant, since it violates the matching principle. Conversely, the allowance method is GAAP-compliant.
Timing of expense recognition. The direct write-off method tends to delay the recognition of a bad expense, while the expense is recorded in the same period as the matching revenue under the accrual method.
Impact on financial statements. The direct write-off method can overstate accounts receivable and income until a bad debt is recognized, while the allowance method provides a more accurate depiction of net accounts receivable and net income.
Effect on accounts receivable. The receivable balance is too high under the direct write-off approach (until a bad debt is recognized), while the reported receivable balance is more realistic under the allowance method.
Complexity. The direct write-off method is simple but can distort financial statements if large bad debts occur, while the allowance method requires estimation, but better reflects the true financial position of the business.
How to Determine Bad Debt Expense
The bad debt expense calculation under the allowance method can be determined in a number of ways. One approach is to apply an overall bad debt percentage to all credit sales. Another option is to apply an increasingly large percentage to later time buckets in which accounts receivable are reported in the accounts receivable aging report. Finally, one might base the bad debt expense 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.
A major concern when developing a bad debt expense is when new products are being sold, since there is no historical information on which the expense estimate can be based. In this case, one option is to base the expense on the most similar product for which the organization has historical data. Another option is to use the industry-standard bad debt expense, until better information becomes available. A third possibility is to begin with a conservative estimate, and then make frequent adjustments to the expense until sufficient historical information is available.
Presentation of Bad Debt Expense
The bad debt expense appears in a line item in the income statement, within the operating expenses section in the lower half of the statement. It is not considered a direct cost of sales.
Example of Bad Debt Expense
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.
Bad Debt Expense FAQs
Can bad debt expense be reversed?
Bad debt expense itself is not reversed because it represents an estimate recorded in the period the credit loss is expected. However, if a previously written-off account is later collected, the recovery is recorded as income and credited to the allowance for doubtful accounts. This recovery increases current-period income without altering the original expense.
How do guarantees or collateral affect the estimate?
Guarantees and collateral reduce expected credit losses when they are legally enforceable, collectible, and directly tied to the receivable. Management considers the guarantor’s financial condition, collateral value, liquidation costs, recovery timing, and seniority. Estimates should reflect only recoveries reasonably expected under applicable accounting standards and documented contractual terms.