Definition — what “bad debt” means
– Bad debt is money owed to a lender or seller that is judged unlikely to be collected. It can arise when a customer or borrower becomes unable or unwilling to pay because of bankruptcy, financial distress, or other reasons. Companies that sell on credit or lend funds must identify and account for these potential losses.
Key accounting concepts and jargon (defined)
– Accounts receivable (AR): amounts customers owe from credit sales.
– Write-off (charge-off): removing a specific receivable from AR because it is uncollectible.
– Direct write-off method: an accounting approach that records bad debt expense only when a particular receivable is deemed uncollectible.
– Allowance method: an approach that estimates uncollectible amounts in advance and records an allowance that reduces AR; this implements the matching principle (expense recognized with related sales).
– Allowance for doubtful accounts: a contra-asset account that offsets AR on the balance sheet to show only the expected collectible amount.
– Bad debt recovery: cash received after a receivable has been written off.
Why businesses must account for bad debt
– Any business that extends credit faces the risk some receivables will not be collected. Proper accounting preserves the matching of expenses with revenues and presents a more accurate net AR balance on the balance sheet.
Two common estimation methods
1) Accounts receivable (AR) aging method
– Group outstanding receivables by how long they’ve been outstanding (e.g., 0–30 days, 31–60 days, 61+ days).
– Apply empirically derived uncollectible percentages to each age group (percent typically rises for older buckets).
– Sum the results to get the total estimated uncollectible amount (required ending balance in allowance for doubtful accounts).
Formula (aging):
Estimated allowance = Σ (AR balance in bucket × % uncollectible for that bucket)
2) Percentage of sales method
– Apply a single historical percentage to the period’s net sales to estimate bad debt expense.
– This produces the bad debt expense for the period; the cumulative allowance balance is updated accordingly.
Formula (percentage of sales):
Bad debt expense = Net sales × estimated uncollectible rate
Journal entries — how to record bad debts
– Under the allowance method:
1) To record estimated uncollectible amounts:
– Debit Bad Debt Expense
– Credit Allowance for Doubtful Accounts
2) To write off a specific account later:
– Debit Allowance for Doubtful Accounts
– Credit Accounts Receivable
3) If a written-off account is later collected:
– Either reverse the write-off first (debit AR, credit Allowance), then record cash (debit Cash, credit AR)
– Or record recovery directly: debit Cash, credit Bad Debt Recovery (or credit Miscellaneous Income), depending on company policy.
– Under the direct write-off method:
– When a receivable is declared uncollectible:
– Debit Bad Debt Expense
– Credit Accounts Receivable
– Note: GAAP generally prefers the allowance method for financial reporting because it matches expense to revenue; the IRS permits the direct write-off method for tax purposes in many cases.
Contra-asset treatment
– The allowance for doubtful accounts is a contra-asset that reduces the total AR shown on the balance sheet. The net figure equals AR less the allowance and represents management’s best estimate of collectible receivables.
Worked numeric examples
Example A — AR aging method (two buckets)
1) Balances:
– AR less than 30 days: $70,000 (expected uncollectible: 1%)
– AR 30+ days: $30,000 (expected uncollectible: 4%)
2) Compute estimated uncollectible:
– 70,000 × 1% = $700
– 30,000 × 4% = $1,200
– Total estimated allowance = $700 + $1,200 = $1,900
3) Journal entry to set allowance (if none exists yet):
– Debit Bad Debt Expense $1,900
– Credit Allowance for Doubtful Accounts $1,900
4) If next period’s aging produces an estimated allowance of $2,500, the additional bad debt expense recorded in that period is $2,500 − $1,900 = $600.
Example B — Percentage of sales method
1) Company expects 3% of net sales will be uncollectible.
2) Period 1: Net sales $100,000 → Bad debt expense = $100,000 × 3% = $3,000.
– Debit Bad Debt Expense $3,000; credit Allowance for Doubtful Accounts $
$3,000.
Period 2 (net sales $120,000 → Bad debt expense = $120,000 × 3% = $3,600)
– Debit Bad Debt Expense $3,600
– Credit Allowance for Doubtful Accounts $3,600
Note: Under the percentage-of-sales method the expense each period is a function of sales, not a target ending balance in the allowance account. The allowance balance accumulates from period to period as the method records expense based on current sales.
Example — Recording a specific write-off (Allowance method)
1) Customer account of $500 is deemed uncollectible.
2) Journal entry to write off:
– Debit Allowance for Doubtful Accounts $500
– Credit Accounts Receivable $500
Effect: Net accounts receivable (Accounts Receivable − Allowance) is unchanged by the write-off; the expense was recognized earlier when the allowance was created.
Example — Recovery of a written-off account
1) Customer unexpectedly pays $500 after being written off. Two-step entry:
a) Reinstate the receivable:
– Debit Accounts Receivable $500
– Credit Allowance for Doubtful Accounts $500
b) Record cash receipt:
– Debit Cash $500
– Credit Accounts Receivable $500
Direct write-off method (definition and example)
– Definition: The direct write-off method records bad debt expense only when a specific account is deemed uncollectible.
– Example: Company writes off a $400 receivable directly:
– Debit Bad Debt Expense $400
– Credit Accounts Receivable $400
– Limitations: This method can violate the matching principle (expenses should be recognized in the same period as related revenues) and can distort profit and receivables timing. It is typically unacceptable under U.S. GAAP for material amounts, though it may be allowed for tax purposes or immaterial balances.
Key formulas and ratios
– Bad debt expense (percentage of sales) = Net sales × Estimated uncollectible %
– Target allowance (aging method) = Sum of (AR in age bucket × estimated uncollectible % for that bucket)
– Additional expense needed = Target allowance − Existing allowance balance
– Allowance coverage ratio = Allowance for Doubtful Accounts ÷ Gross Accounts Receivable
– A higher ratio implies a larger reserve relative to receivables.
– Receivables turnover = Net credit sales ÷ Average accounts receivable
– Higher turnover suggests faster collection; pair with allowance trends to assess credit risk.
Checklist — How to estimate and record bad debts (practical steps)
1) Choose an estimation method (aging of receivables or percentage of sales) that fits the company’s business and historical experience.
2) Gather inputs: aging schedule, historical write-off rates, current economic indicators, major customer concentrations.
3) Calculate estimated uncollectible amount and determine target allowance (if using aging).
4) Compute the adjusting entry: required adjustment = target allowance − current allowance balance.
5) Record journal entry: Debit Bad Debt Expense (or credit if reversing) and credit/debit Allowance for Doubtful Accounts accordingly.
6) Document assumptions and supporting schedules for auditors and disclosures.
7) Monitor recoveries and write-offs, and reverse entries if a recovery occurs.
Financial-statement effects and what to watch for (analysis tips)
– Income statement: Bad Debt Expense reduces net income when recorded.
– Balance sheet: Allowance for Doubtful Accounts reduces gross receivables to present net realizable value.
– Analyst checks: Look for sudden changes in allowance policy or unusually large one-time adjustments. Compare allowance coverage and bad-debt percentages across peers and time. Consistently low allowances with rising delinquent receivables can signal under-reserving.
Assumptions and limitations
– Estimates rely on historical data and judgment; changes in credit policy, economic conditions, or customer base can invalidate past rates.
– No method produces a perfect prediction — disclosures should explain significant assumptions and changes.
Regulatory and tax notes (brief)
– U.S. GAAP requires allowance-based recognition when materially appropriate; specific guidance appears in the FASB Accounting Standards Codification.
– Tax rules for deducting bad debts differ from GAAP; consult tax authorities or a tax professional for specific treatment.
Educational disclaimer
This content is educational and does not constitute individualized investment, accounting, or tax advice. For decisions about financial reporting or taxes, consult a qualified accountant or tax advisor.
Sources
– Investopedia — Bad Debt: https://www.investopedia.com/terms/b/baddebt.asp
– Financial Accounting Standards Board (FASB) — Accounting Standards Codification: https://asc.fasb.org/
– U.S. Securities and Exchange Commission (SEC) — Financial Reporting Manual: https://www.sec.gov/corpfin/cf-manual
– Internal Revenue Service (IRS) — Deducting Business Bad Debts: https://www.irs.gov/businesses/small-businesses-self-employed/deducting-bad-debts