How to Calculate and Avoid a Bad Debt Expense

Bad debt expense is an inevitable part of doing business on credit because there’s always a risk that your customers may not pay. There are two ways to record a bad debt on a company’s accounts: the direct write-off method and the allowance method. A bad debt expense can be recorded as identified, or the expense can be estimated using the allowance method when the sale occurs.  

What Is a Bad Debt Expense?

Bad debt is an amount that a business must write off if a customer defaults on the credit you extended. If the creditor does not pay, the account becomes uncollectible and must be recorded as a charge-off.

Bad debt is a contingency that all businesses must account for when you extend credit because there’s always a risk that you won’t be able to collect a payment. You can estimate what percentage of your receivables may become uncollectible using multiple methods, such as percentage of sales, percentage of receivables, or accounts receivable aging.

How To Record a Bad Debt Expense

There are two main ways of recording a bad debt expense in your accounting statements, depending on whether the customer has already defaulted or if you are anticipating that you won’t pay.

Direct Write-Off

Before you can write off bad debt, you’ll need to satisfy these IRS conditions:

• You have evidence that the debt is worthless.
• You can demonstrate debt worthlessness by making reasonable collection efforts to recover the amount owed.  

Using the write-off method, you can record a bad debt by simply debiting the bad debt account and crediting your accounts receivable. It’s best to use this method when you only have a few uncollected accounts because it can confuse accounting entries if your bad debt expense journal entry is in a different period than the sales entry.

Allowance Method

The allowance account method anticipates that the business won’t be able to collect a portion of the accounts receivable. There’s no firm knowledge of which customers won’t pay, but the company can still debit bad debt expenses and credit Allowance for Doubtful Accounts (AFDA).

To use the allowance method to record a bad debt, you’ll first need to create and estimate an AFDA journal account. Calculate your actual bad debts and debit bad debt expense accounts and credit AFDA on your income statement. You can then debit AFDA and credit accounts receivable on the accounts receivable balance sheet to comply with the matching principle.

How To Estimate a Bad Debt Expense

To determine the exact amount to list on the financial statements, you’ll need to estimate the uncollectible balances using one of these methods.

Percentage of Sales

You can estimate bad debt expense by a percentage of sales based on the business’s historical experience with uncollectible accounts. Using this method, you can apply a flat percentage to the total sales amount for a period to calculate doubtful debts.

Here’s how to use the percentage of sales method. Let’s consider that your business estimates that 5% of net sales are not collectible. If the net sales for the period are $100,000, you can report $5,000 ($100,000 X 5%) in bad debt expense.

Percentage of Receivables

In this method, you’ll use accounts receivable instead of net sales. The method works similarly to the percentage of sales. Based on the historical percentage of uncollected receivables, you’ll use a percentage to estimate the bad debt allowance for a period.

For example, if your receivables balance is $200,000 and the historical percentage of uncollected receivables is 8%, your estimated uncollectible amount will be $16,000 ($200,000 x 8%). This is the amount you’ll record on your accounts receivable balance sheet.  

Accounts Receivable Aging

With the aging method, you’ll group all outstanding accounts receivable by age and apply specific percentages. The aggregate of the results is the estimated bad debt amount. As the age of the accounts increases, the percentage will usually increase to reflect the rising risk of default.

Let’s say a business has $50,000 of accounts receivable less than 30 days due and $20,000 over 30 days due. Based on historical estimates, 2% of accounts receivable less than 30 days due will be uncollectible, and 4% of those that are over 30 days due are uncollectible.

Here’s how to report a bad debt expense for this example:

• $50,000 x 2%= $1000
• $20,000 x 4%= $800
• Total amount of bad debt: $1,800

Which Method Do Businesses Use Most?

Brad Reichert, founder and managing director of Reichert Asset Management LLC, explains how businesses are likely to account for bad debt.

“For businesses that sell their products or services mostly on longer-term credit to their customers (60, 90, or 120 or more days), the Percentage of Receivables method of estimating Bad Debt Expense is usually most appropriate,” Reichert says. “This happens since a majority of their sales are ‘tied up’ in receivables for a longer period of time (as measured by the Days Sales Outstanding formula), during which the risk of a customer defaulting is much higher.”

Reichert adds, “For businesses that sell their products on shorter credit terms (30 days or less), the Percentage of Sales method is usually the most appropriate because the Accounts Receivable balance and Day Sales Outstanding number is usually much lower.”

Why Bad Debt Happens

Bad debt and charge-offs can happen for many reasons. Poor communication between customers and the accounts receivable department due to being out of touch with customer needs can be a major reason. In many instances, sales teams may offer credit terms to customers without any input from the accounts receivable department, creating misunderstandings.

In other cases, customers may refuse to pay if they’re unsatisfied with the service or product. Some customers cannot afford to pay outstanding bills because they’re dealing with mounting business debt or have filed for bankruptcy.

3 Tips To Avoid Bad Debt Expenses

It’s impossible to eliminate the risk of bad debt, but there are ways to minimize it through clear customer communications, timely follow-ups, and payment terms.

1. Assess Customer Creditworthiness

Assessing the creditworthiness of new accounts is important to avoid bad debts. When extending credit to a new customer, always run a credit check. You can ask for trade references if you’re working with other businesses. Start with a small credit limit and increase it once the customer has cleared their bills promptly.

2. Establish Clear Payment Terms

Discuss your payment terms and credit policy with customers and ensure no misunderstandings. Payment terms should also be stated clearly on statements and invoices, including late payment charges. You won’t be able to enforce the terms if you haven’t made them clear and easily accessible.

3. Follow Up and Collect

Send statements and invoices as soon as they’re due and follow up to collect once they become overdue. If there’s a problem with customer payments, put accounts on hold or reduce credit limits. Regular follow-ups for repayment will ensure the outstanding balance your customers owe does not balloon to become unmanageable for them.

Example of Bad Debt Expenses

The best way to understand bad debt expenses and how they should be recorded is through an example. Suppose your business recorded $1 million in net revenue during the year. Based on historical data, you estimate that 1% of the net revenue will be bad debt.

Your estimated bad debt expense should be $10,000 based on your bad debt assumption. This should be recorded in the “Bad Debt Expense” account and a credit entry to AFDA.

On the business’s income statement, this bad debt expense should be recorded in the current accounting period, and the accounts receivable line item on the balance sheet must be reduced by the allowance for the doubtful accounts. Here’s a journal entry for this example:

Get Financial Stability for Your Business  

Bad debt is an unavoidable part of businesses that involves credit sales. In any business, a portion of customers will likely not pay their bills, so it’s important to earmark a percentage of accounts receivable as bad debt.

You can account for it by debiting a bad debt account and crediting a contra asset account. Businesses can also use a write-off method for no longer collectible accounts, although it doesn’t comply with Generally Accepted Accounting Principles (GAAP).