Guide to calculating bad debt expense: Methods & examples

Managing expenses in finance and accounting can be challenging. One essential aspect of this process is calculating bad debt expense, which refers to account receivables that a business cannot collect due to a customer’s inability to fulfill financial obligations. 

‍

This comprehensive guide will provide a detailed understanding of bad debt expense, including how to calculate it and the two methods involved. We will also provide examples of each technique with journal entries.

How to calculate bad debt expense

Calculating bad debt expense is an integral part of financial management. There are two ways to calculate bad debt expenses - the direct write-off method and the allowance method.

Direct write-off method for a bad debt expense

The direct write-off method for bad debt expenses involves writing off the receivables account. When it becomes clear that a customer invoice will remain unpaid, the invoice amount is charged directly to bad debt expense and removed from the accounts receivable. The bad debt expense account is debited, and the accounts receivable account is credited. However, this method has some downsides. It fails to uphold the Generally Accepted Accounting Principles (GAAP) principles and the matching principle used in accrual accounting.

Example of the direct write-off method

Suppose a small retail business has sold $10,000 to a customer on credit. However, the customer has not paid the amount due for a considerable time, and it has become evident that the business will not be able to recover $5,000 of the outstanding amount.

‍

The business must create a journal entry to reflect the loss in such a situation. The entry will require debiting the Bad Debt Expense account for $5,000, representing an expense for the business. It will credit the accounts receivable account by the same amount, reducing the amount the customer owes.

‍

By creating this journal entry, the business can accurately reflect the actual value of its accounts receivable and financial position. It also ensures that the business's financial statements are balanced, and its tax liability is calculated correctly.

Bad debt expense formula: Direct write-off method

‍

Allowance method for a bad debt expense

The allowance method is used to predict bad debts before they happen. To do this, an allowance for doubtful accounts is created based on an estimated amount - the money the business expects to lose each year. This account reduces the business loan receivable account when both are listed on the balance sheet.

‍

When accountants record sales transactions, they also record the related amount of bad debt expense. This is recorded as a debit to the bad debt expense account and a credit to the allowance for doubtful accounts. At the end of the year, the unpaid accounts receivable is zeroed out by using the amount in the allowance account.

Example of the allowance method

Imagine that a small business owner has been running a company for three years. Over the years, it has built up a loyal customer base and has always been able to collect payments on time. However, a longtime customer has recently gone out of business, leaving a balance of $10,000 on their account.

‍

There is concern about the impact this will have on the business's finances, and it is becoming unlikely they will be able to collect the total amount. After consulting with their accountant, they estimate that 20% of the accounts receivable is uncollectible.

‍

A journal entry must be made to adjust the financials for the anticipated risk. In this case, we will debit the Bad Debt Expense account for $2,000, representing 20% of the $10,000 total balance. The credit will go to the Allowance for Doubtful Accounts account for the same amount. This adjustment will help us accurately reflect the actual value of the accounts receivable and provide a more accurate financial picture of the business. 

Bad debt expense formula: Allowance method

‍

‍

‍

Estimating bad debt

Estimating bad debt is another critical aspect of financial management. There are two ways to estimate bad debt - the percentage of accounts receivable method and the percentage of sales method.

Percentage of accounts receivable method

To estimate bad debts, businesses can use the percentage of accounts receivable method. This involves calculating bad debts as a percentage of the accounts receivable balance.

‍

Estimating bad debt can be done using either the percentage of accounts receivable method or the percentage of sales method. Understanding bad debt expense can help businesses make informed decisions and ensure their financial healthFor example, if a business has $50,000 in accounts receivable and historical records indicate an average 5% of total accounts receivable become uncollectible, the business can set aside an allowance for bad debts accounts to have a credit balance of $2500 (5% of $50,000). An aging schedule can also be used to estimate bad debts.

Percentage of sales method

One way to estimate bad debts is to use the percentage of sales method. This involves calculating the percentage of total credit sales that are unlikely to be collected. Factors such as customer experience and the credit policy in place are taken into consideration to arrive at this percentage. Once the percentage is determined, it is multiplied by the total credit sales for the relevant period.

‍

Suppose a company has total credit sales of $100,000 for a period. Based on experience and the credit policy in place, the company determines that 5% of those sales are likely to be uncollectible. Using the percentage of sales method, the estimated bad debts for that period would be $5,000 (5% x $100,000). This amount can then be recorded as an expense on the company's income statement to reflect the expected losses from uncollectible accounts.

Bottom line

Calculating bad debt expense is a crucial aspect of financial management. There are two ways to calculate bad debt expense: the direct write-off method and the allowance method. While the direct write-off method records the exact amount of uncollectible debts, it fails to uphold the GAAP principles and the matching principle used in accrual accounting. On the other hand, the allowance method anticipates bad debts before they occur. 

‍

Estimating bad debt can be done using either the percentage of accounts receivable method or the percentage of sales method. Businesses can make informed decisions and ensure their financial health by understanding bad debt expense.