Bad debt expense accounts receivable, which are noncollectable when a customer cannot fulfil the financial obligations. The two different methods for calculating bad debts are:
- The direct write-off method
- The allowance method
It indicates the business loss due to the delay in payment for sold goods and services. The financial statement shows the bad debts as the provision for credit losses.
This article covers:
- How do you find bad debt expenses?
- How do you calculate bad debt?
- What methods to use for estimating bad debts?
- How do you record bad debt expenses?
How Do You Find Bad Debt Expenses?
Businesses make deals with their customers sometimes by offering goods and services on credit; that is a risky situation because most of the time, customers do not pay their debts, and the amount then goes to bad debt expenses. It simply indicates the business loss.
If your customer is unwilling to pay the pending invoices and crosses 90 days for unpaid invoices, you can write off these expenses as bad debts. It gives you a clear picture of your financial status and helps you avoid misstating your revenues, assets, and relevant income.
How To Calculate Bad Debt Expenses?
The two methods for calculating bad debts are:
- Direct write-off method
- Allowance method
Direct Write-off Method:
It refers to the write-off of receivable accounts. After confirming the unpaid invoice, the amount shifts to the bad expense from the accounts receivable. Bad debt expense refers to debited, whereas accounts receivable account is credited.
Drawback:
It does not follow the GAAP principles and the matching principles of accrual accounting. There is no allowance account in this method.
You can write off the small expenses using this method, as it records the exact amount of noncollectable debts. The right time for recognizing the expenses is the time of transaction rather than the time of payment. It is not a theoretically right method for identifying bad debts.
Allowance Method:
This method involves the estimation of bad debts before they occur. Businesses establish an allowance for doubtful accounts in advance. Businesses anticipate the amount they expect to lose every year. The contra-asset reduces the loan receivable account while listing the balances in the balance sheet.
The accountants record the amount of bad debt expense while recording sales transactions. The record shows the debit to the bad debt account and credit to the allowance for doubtful accounts. Drawing down the allowance account; reduces unpaid accounts receivable to zero at the end of the year.
What Methods To Use For Estimating Bad Debts?
There are two methods for estimating bad debts as per GAAP. These are:
- Percentage of accounts receivable method
- Percentage of sales method
Percentage of accounts receivable method:
Under this method, businesses can find the estimated value of bad debts by calculating it as a percentage of accounts receivable balance.
For example:
Suppose your business has $30000 in accounts receivable by the end of a year, and your historical record shows bad debts of 5%. In that case, you need to keep an allowance for bad debt accounts to have a credit balance of 5% of the total amount of accounts receivable, which is $1500.
Percentage of sales method:
This method involves determining the percentage of total non-collectible credit sales. Here, the experience with customers and anticipated credit policy plays an important role.
To determine the bad debt expenses, multiply the percentage by the total credit sales of a business.
For example:
Suppose a business reports total credit sales of $300,000. If they estimate that 5% of credit sales is non-collectible, the business estimates that it will incur $1500 (30,000 x 5) as a bad expense.
How Do You Record Bad Debt Expenses?
If you are using the allowance method for calculating bad debts, there are
- Two general ledger accounts
- Bad expense account
- Allowance for doubtful accounts
- Contra assets accounts
Utilize them to offset the accounts receivable balance.
You must debit bad debt expenses and credit allowance for doubtful accounts to record the bad debt expenses.
| Date | Account | Reference | Debit | Credit |
| 29-June-18 | Bad Debt Expense | $200 | ||
| Allowance for Doubtful accounts | $200 | |||
| 01-July-18 | Allowance for Doubtful accounts | $200 | ||
| Accounts Receivable | $200 |
If you are using a write-off method, then you should report the entire balance in accounts receivable as a current asset on the balance sheet. It shows the debt to the accounts receivable and credit to the bad debt expense account.
| Date | Account | Reference | Debit | Credit |
| 29-June-18 | Bad Debt Expense Account | $200 | ||
| Accounts receivable | $200 |
Businesses must record and account for bad debt expenses while preparing their financial statements. Avoiding any minor detail can lead to serious misconceptions about assets and income evaluation.
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