Bad Debt Expense: Definition and How to Calculate It Bench Accounting

In other words, there is nothing to undo or balance as bad debt if your business uses cash-based accounting. The allowance method estimates bad debt expense at the end of the fiscal year, setting up a reserve account called allowance for doubtful accounts. Similar to its name, the allowance for doubtful accounts reports a prediction of receivables that are “doubtful” to be paid. Let’s say that the following accounting period results in net sales of $80,000. This would mean that an additional $2,400 would be reported in the allowance for doubtful accounts and bad debt expense.

Percentage of Accounts Receivable Method

You’ll calculate your bad debt allowance for each aging bucket then add these totals all together to find your ending balance. Here’s an example of an accounts receivable aging report with collection probabilities that add up to a total bad debt reserve. Having a good grasp of bad debt expenses will make for more accurate, transparent, and useful financial records.

Methods of Estimating Bad Debts Under the Allowance Method

• Under this direct approach for estimating the expense, the increase in the allowance is computed indirectly.
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• Thus, the bad debt expense is estimated indirectly as the change in the allowance.
• This impacts the taxpayer’s ability to offset ordinary income as effectively as business bad debts.
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The result of your calculation in the percentage of sales method is your adjustment to the AFDA balance. So, when recording allowance for doubtful accounts on the accounts receivable balance sheet, you’ll add any existing AFDA balance (from the year prior) to the adjustment balance to find the ending balance. When recording bad debt expense on the income statement, however, you’ll just record the adjustment value.

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Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more – straight to your e-mail. Vivek Shankar specializes in content for fintech and financial services companies. He has a Bachelor’s degree in Mechanical Engineering from Ohio State University and previously worked in the financial services sector for JP Morgan Chase, Royal Bank of Scotland, and Freddie Mac. Vivek also covers the institutional FX markets for trade publications eForex and FX Algo News. Let’s say that you own an electronics company and you make a sale to a customer worth $1,000. The customer uses store credit to make the purchase and receives your product upfront.

Recording a bad debt expense for the allowance method

Once the estimated bad debt figure materializes, the actual bad debt is written off on the lender’s balance sheet. The sale from the transaction was already recorded on the income statement of the company since the revenue recognition criteria per ASC 606 were met. The Bad Debt Expense is a company’s outstanding receivables that were determined to be uncollectible and are thereby treated as a write-off on its balance sheet.

Example of Bad Debt Expense

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• For instance, if a business wrote off $10,000 in 2022 and recovered $2,000 in 2023, the $2,000 must be reported as income on the 2023 tax return.
• For example, a loan agreement with clear terms, including interest rates and repayment schedules, typically satisfies this requirement.
• For example, in one accounting period, a company can experience large increases in their receivables account.
• An allowance for doubtful accounts is considered a “contra asset,” because it reduces the amount of an asset, in this case the accounts receivable.
• In addition to bad debts, there are several other reasons why a company may fail to collect the face amount of its receivables.

Bad debt expense is an accounting entry that lists the dollar amount of receivables your company does not expect to collect. Learn how to calculate bad debt expense and the various methods of recording it in this blog. The percentage of receivables method is otherwise known as the balance sheet approach.

Do you own a business?

For example, at the end of the accounting period, your business has $50,000 in accounts receivable. Let’s assume that a company called Larry’s Lumber sells a shipment of wood to a company called Terri’s Toys, which uses the materials to create its products. The uncollectibility rates above must be based on experiences with customers—it should not be arbitrary. As the receivable remains outstanding for a longer time, the uncollectibility rate increases because it becomes more evident that the customer cannot pay.

In the latter scenario, the customer might never have had the intent to pay the seller in cash. Given the prevalence of paying on credit in the modern economy, such instances have become inevitable, although improved collection policies can reduce the amount of write-offs and write-downs. While hiring a collection agency can be expensive (they typically take a percentage of the recovered amount), it is often a better alternative than writing off the debt entirely. Businesses should weigh the cost of using a collection agency against the likelihood of recovery before making a decision. The longer a business waits to follow up on overdue accounts, the less likely they are to recover the full amount. Research shows that the probability of collecting on a debt drops significantly after 90 days.

She supports bad debt expense small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business. Larry’s Lumber sends the shipment of wood to Terri’s Toys, as well as an invoice for $5,000. Due to unforeseen financial circumstances, however, Terri’s Toys cannot pay the invoice on time. Despite Larry’s Lumber attempting to collect the $5,000 several times, they decide that they are very unlikely to be successful. Bad debt deductions are subject to IRS scrutiny and potential disallowances.