Definition
– Bad debt expense is the portion of sales on credit that a company does not expect to collect. It represents an estimate of customer accounts receivable that will become uncollectible because customers fail to pay (for example, due to bankruptcy or insolvency).
Where it appears in the financial statements
– Income statement: bad debt expense is recorded as an operating expense (often under selling, general & administrative expense).
– Balance sheet: the expected uncollectible amount is reported as a contra-asset called Allowance for Doubtful Accounts (or Provision for Credit Losses) that reduces Accounts Receivable.
Two main recording approaches
1. Direct write-off method
– When a specific receivable is judged uncollectible, it is removed from receivables and charged directly to expense.
– Journal entry when account is written off:
– Debit Bad Debt Expense
– Credit Accounts Receivable
– Notes: simple and exact for that receivable, but it often breaks the matching principle (expense may be recognized in a different period than the related revenue). In the U.S., the direct write-off method is still commonly used for tax purposes.
2. Allowance (estimate) method
– Management estimates the amount of receivables that will be uncollectible and records that estimate in an allowance (contra-asset) account.
– Initial estimate entry:
– Debit Bad Debt Expense
– Credit Allowance for Doubtful Accounts
– When a specific account is later written off:
– Debit Allowance for Doubtful Accounts
– Credit Accounts Receivable
– Notes: this approach follows accrual accounting and the matching principle by recognizing estimated losses in the same period as the related sales.
Common ways to estimate bad debt
1. Aging of accounts receivable (detailed, balance-sheet driven)
– Group outstanding receivables by age bucket (0–30 days, 31–60 days, etc.).
– Apply higher uncollectibility rates to older buckets.
– Sum the results to get the target allowance balance and record the adjusting entry equal to (target allowance − existing allowance balance).
2. Percentage of sales (income-statement driven)
– Apply a single historical percentage to credit sales (or net sales) to estimate bad debt expense for the period.
– Produces an expense amount directly; the allowance account is adjusted to reflect cumulative estimates.
Step-by-step checklist for recording bad debt (practical)
1. Confirm accounting policy (direct write-off vs. allowance) and relevant accounting standards.
2. Attempt collection and document collection efforts for each delinquent account.
3. Choose an estimation method (aging, percentage of sales, statistical model) that fits the business and available data.
4. Calculate the estimated uncollectible amount:
– For allowance method: compute target allowance; determine required adjustment = target − current allowance.
– For direct write-off: identify specific account(s) to write off.
5. Post journal entries (see examples below).
6. Keep supporting schedules (aging, calculations, historical rates).
7. Disclose accounting policy and material changes in estimates in the financial statement notes.
8. Coordinate with tax rules (tax authorities may require direct write-off for deductions).
Worked numeric examples
A. Aging method (two periods, allowance method)
– Receivables:
– 0–30 days: $70,000; expected uncollectible rate 1% → $700
– 31+ days: $30,000; expected uncollectible rate 4% → $1,200
– Target allowance = $700 + $1,200 = $1,900
– If allowance balance at period start is $0, record:
– Debit Bad Debt Expense $1,900
– Credit Allowance for Doubtful Accounts $1,900
– If next period the recalculated target allowance becomes $2,500, required adjustment = $2,500 − $1,900 = $600. Record:
– Debit Bad Debt Expense $600
– Credit Allowance for Doubtful Accounts $600
B. Percentage of sales method (income-statement approach)
– Net credit sales for the period = $100,000
– Historical
Historical bad-debt rate = 2% (example assumption)
– Net credit sales for the period = $100,000
– Bad debt expense (percentage-of-sales) = 100,000 × 2% = $2,000
Journal entry (income-statement approach; allowance method used to record expense):
– Debit Bad Debt Expense $2,000
– Credit Allowance for Doubtful Accounts $2,000
Notes:
– This method computes expense directly from the income statement (sales), not from the balance-sheet receivables balance. It is useful when management wants expense to reflect current period sales performance.
– If the allowance already has a balance, you still record the expense amount above; the allowance account’s ending balance will equal prior balance + $2,000.
Worked example with prior allowance balance
– Beginning Allowance for Doubtful Accounts = $1,200 (credit)
– Required percentage-of-sales entry = $2,000
– Ending Allowance = $1,200 + $2,000 = $3,200
Common journal entries for actual uncollectible accounts
1) To write off a specific customer account (under the allowance method):
– Suppose Customer X’s AR $800 is determined uncollectible.
– Debit Allowance for Doubtful Accounts $800
– Credit Accounts Receivable $800
Effect: No income statement impact at write-off time because expense was already estimated and recorded earlier.
2) Recovery of a previously written-off account:
– If Customer X later pays $300, typical two-step entry:
a. Reinstate receivable:
– Debit Accounts Receivable $300
– Credit Allowance for Doubtful Accounts $300
b. Record cash collection:
– Debit Cash $300
– Credit Accounts Receivable $300
Alternative: Some entities record a “Bad Debt Recovery” income if they prefer to show recoveries separately; the two-step reinstatement then collection keeps presentation neutral (no net additional expense).
Effects on financial statements (brief)
– Income statement: Bad Debt Expense reduces net income in the period recorded.
– Balance sheet: Allowance for Doubtful Accounts is a contra-asset that reduces Gross Accounts Receivable to present Net Realizable Value (NRV).
– Ratios: Higher allowances reduce receivables turnover and increase days sales outstanding (DSO) when NRV falls; however, these changes reflect expected collectibility, not cash flows.
Key controls and checklist for estimating bad debts
– Maintain an aging schedule of receivables (0–30, 31–60, 61–90, 91+ days).
– Update historical loss rates periodically (quarterly or when macro conditions change).
– Reconcile allowance account monthly and document management’s rationale for rate changes.
– Require approval and documentation for all write-offs.
– Segregate duties: different people for credit approval, collections, and write-offs.
– Use independent review (audit or internal audit) of methodology and assumptions annually.
Practical tips for small businesses and practitioners
– If credit sales are a small portion of revenue, percentage-of-sales may be simpler; if receivables vary widely by age or customer, aging method gives more accuracy.
– During economic downturns, increase loss-rate conservatism and document why.
– Keep a sample-level analysis of large customers—one big default can distort percentages.
– Use scenario testing: show allowance under optimistic, base, and pessimistic rates to understand sensitivity.
Common mistakes to avoid
– Treating the allowance as a “slush fund.” Management must not use allowance adjustments to manage earnings. Changes in the allowance should be tied to documented changes in receivable collectability, not to meet targets.
– Relying on a single, stale loss rate. Using one historical percentage without considering current economic conditions, customer mix, or seasonality yields poor estimates.
– Ignoring concentration risk. A few large customers can dominate outcomes; a single default can make population-based percentages misleading.
– Failure to analyze large or unusual balances individually. Material receivables require specific assessment rather than being lumped into a roll-rate.
– Not reconciling and documenting account movements. Reconcile the allowance to write-offs and recoveries monthly and retain working papers explaining rate changes.
– Mixing accounting and tax treatments. The allowance method is a GAAP (or IFRS) concept; tax rules for deducting bad debts differ by jurisdiction. Treat tax and financial reporting as separate analyses.
– Weak internal controls. Letting the same person authorize credit, post collections, and approve write-offs increases fraud and error risk.
Worked examples — two common estimation approaches
1) Aging-of-receivables (balance-sheet approach)
Assumptions:
– Ending accounts receivable (AR): $200,000, split by age:
– 0–30 days: $120,000 at 1% uncollectible
– 31–60 days: $50,000 at 5%
– 61–90 days: $20,000 at 15%
– >90 days: $10,000 at 50%
– Existing Allowance for Doubtful Accounts (credit balance): $1,500
Step 1 — Calculate required allowance:
– 0–30 days: $120,000 × 1% = $1,200
– 31–60 days: $50,000 × 5% = $2,500
– 61–90 days: $20,000 × 15% = $3,000
– >90 days
= >90 days: $10,000 × 50% = $5,000
Total required allowance = $1,200 + $2,500 + $3,000 + $5,000 = $11,700
Existing Allowance for Doubtful Accounts (credit balance): $1,500
Bad debt expense required (adjustment) = Required allowance − Existing allowance
= $11,700 − $1,500 = $10,
200 = $10,200
Step 2 — Record the adjusting journal entry
– Entry to recognize bad debt expense under the allowance method:
– Debit Bad Debt Expense $10,200
– Credit Allowance for Doubtful Accounts $10,200
Rationale: the allowance account is a contra-asset that reduces accounts receivable on the balance sheet. After this entry, the Allowance for Doubtful Accounts will equal the required allowance calculated from the aging schedule.
Step 3 — Show post-adjustment balances (worked numbers)
– Accounts Receivable (gross): $200,000
– Allowance for Doubtful Accounts (credit) before adjustment: $1,500
– Adjustment (credit): $10,200
– Allowance for Doubtful Accounts (credit) after adjustment: $1,500 + $10,200 = $11,700
– Accounts Receivable, net (Net Realizable Value) = $200,000 − $11,700 = $188,300
Verification check: required allowance from aging = $11,700; allowance after adjustment = $11,700 → matches.
Income statement effect (worked example)
– Bad Debt Expense recorded = $10,200
– That reduces pre-tax income by $10,200 in the period the adjustment is made.
– After-tax effect = $10,200 × (1 − tax rate). Example: if tax rate = 25%, after-tax net income impact = $10,200 × 0.75 = $7,650 reduction in net income.
Cash flow effect
– No immediate cash flow effect when recording the allowance. The expense reduces operating cash flow only when using indirect cash flow reconciliation (net income adjusted for noncash items). Actual cash collection impact occurs later when specific accounts are written off or collected.
Subsequent write-off of a specific customer account (how to record)
– When a specific $3,000 receivable is deemed uncollectible:
– Debit Allowance for Doubtful Accounts $3,000
– Credit Accounts Receivable $3,000
– Effect: allowance and gross AR both fall; net AR (NRV) is unchanged by the write-off because the allowance already absorbed the expected loss.
If a previously written-off account is recovered (customer pays)
– Typical entries:
1) Reinstate receivable (reverse write-off):
– Debit Accounts Receivable, Credit Allowance for Doubtful Accounts
2) Record cash collection:
– Debit Cash, Credit Accounts Receivable
Checklist: Aging method adjustment
1. Prepare an aging schedule that groups AR by age buckets.
2. Apply appropriate uncollectible percentages to each bucket.
3. Sum to get required allowance.
4. Compare required allowance to existing allowance balance (note debit vs. credit).
5. Record adjusting entry = required allowance − existing allowance (if existing is a credit). If existing is a debit (i.e., prior period under-accrual), add that debit to the adjustment.
6. Recalculate net AR and disclose accounting policy for bad debts.
Assumptions and notes
– This example uses the allowance method (a contra-asset approach) rather than the direct-write-off method. The allowance method conforms with accrual accounting and typically GAAP.
– Percentages in aging schedules are estimates based on historical collectability and judgement—actual write-offs can differ.
– Tax treatment varies by jurisdiction; consult tax guidance for when bad debt deductions are allowed.
Relevant authoritative/introduction resources
– Investopedia — Bad Debt Expense: https://www.investopedia.com/terms/b/bad-debt-expense.asp
– Financial Accounting Standards Board (FASB) ASC 450, Contingencies (overview): https://asc.fasb.org/
– U.S. IRS — Business Bad Debts (general guidance): https://www.irs.gov/taxtopics/tc505
– AccountingCoach — Allowance for Doubtful Accounts: https://www.accountingcoach.com/blog/allowance-for-doubtful-accounts
– Corporate reporting example/discussion (PwC): https://pwc.com
Educational disclaimer
This explanation is for educational purposes only and not individualized investment, accounting, or tax advice. Consult a licensed accountant or tax professional for guidance specific to your situation.