What Is a Bad Debt Expense and How Do I Calculate It?
As a small business owner, you rely on accurate bookkeeping to ensure you run a profitable enterprise. Well-organized financial documentation allows you to keep track of income, chase unpaid invoices, identify budgetary bottlenecks, and pinpoint areas that could be more cost-efficient.
One important point to keep track of is bad debt expenses. This term refers to accounts receivable (money you're owed) that you can no longer collect because the customer is unable to pay. For small businesses that don't have the financial cushion of major corporate finance departments, tracking bad debts expenses is critical.
The below guide gives additional details about bad debt expenses, explains how they might impact you as a small business owner, and provides a step-by-step guide on how to calculate them.
What Is a Bad Debt Expense?
If you do business on credit (meaning you provide a good or service before the customer or client has paid for it), you may run into bad debt expenses. You may also see bad debt expenses referred to as doubtful debt, doubtful accounts, or uncollectible accounts.
If a customer or client owes you money but is unable to pay the amount due, you won't be able to collect the debt owed. For example, you might perform a service and provide the customer with an invoice specifying that they should pay you within 30 calendar days (Net 30 payment terms). But what happens if that customer then files for bankruptcy? Presumably, they won't have the money to pay your bill.
If you conclude that a bad debt is impossible to collect, it can become a bad debt expense and negatively impact your company's current asset accounts receivable. Depending on the type of accounting method you use, you may have to record it as an expense in your bookkeeping. This depends on whether you use an accrual or cash accounting method:
- Accrual accounting: With accrual accounting, you recognize and record revenue as soon as it's earned. As soon as you invoice a customer, you may count that invoice to your revenue even if the customer hasn't paid it yet. If you use the accrual accounting method, you have to reverse the bad debt because you've already claimed it as income.
- Cash accounting: With cash accounting, you only count revenue as such once the cash actually hits your account. If you use the cash accounting method, you don't have to "reverse" the bad debt because you will not have claimed it as income yet.
How to Estimate a Bad Debt Expense
There are two methods you can use when it comes to determining an estimated amount of bad debt: percentage of accounts receivable or percentage of sales. Here's how to use either method.
Percentage of Accounts Receivable Method
Following this method, you estimate the value of your bad debts by calculating them as a percentage of your company's accounts receivable balance.
Let's say you have $10,000 in accounts receivable at the end of your current account period, for example. You typically can't collect on 10% of those accounts receivable: 10% of $10,000 is $1,000. Thus, you will have a credit balance of $1,000 and need to put aside an allowance for this bad debt account.
Percentage of Sales Method
With this approach, you estimate bad debts based on the percentage of uncollectible total credit sales. You also factor in your past experiences with the customer, considering their repayment history and the expected credit policy.
Let's say you have $20,000 in net credit sales at the end of your current account period. Based on the percentage of sales method, you estimate that 10% of your credit-based sales can't be collected. You will thus incur $2,000 in bad debt expense.
How Do You Record a Bad Debt Expense?
Above, we talked about estimating bad debt expenses. However, you also have to calculate bad debt expenses as business credit losses.
You can use the direct write-off method or the allowance method. With the direct write-off method, you take the amount of the unpaid invoice and charge it directly to the bad debt expense, removing it from your accounts receivable. With the allowance method, you anticipate the bad debt before it's incurred, setting an allowance in advance.
Both approaches are detailed below.
Method 1: The Direct Write-Off Method
This approach requires a write-off to your accounts receivable account. The invoice amount is removed from accounts receivable and charged as a bad debt expense. Thus, the accounts receivable account is credited X amount and your bad debt expense account is debited that same X amount. There is no allowance account.
Here's how this might appear in your accounting journal entry:
|Allowance for bad debts||$200||-|
Method 2: The Allowance Write-Off Method
This approach allows you to anticipate the bad debt expense before it's incurred. You estimate an allowance for your bad debt expense using one of the aforementioned techniques and the figure you end up with is the amount of money you anticipate losing to the bad debt expense every year.
The following entry shows what this might look like in your accounting journal:
|Bad debt expense||$2,000||-|
|Allowance for bad debts||-||$2,000|
Which Method Should You Use?
So, which method is right for you? Ultimately, it's your choice. However, be aware that the direct write-off method doesn't meet the Generally Accepted Accounting Principles (GAAP), which are considered best practice by many professionals. Further, publicly traded companies are required by U.S. law to release key financial statements in line with the GAAP.
The direct write-off method also fails to meet the matching principle used in accrual accounting. This principle requires that expenses incurred in a set accounting period are recorded within the same accounting period of time in which any revenues related to those expenses were earned.
For example, if you have a $10,000 invoice for a project that incurred $3,000 worth of expenses to complete (e.g., paying for manpower and materials), you'd want the invoice and expense notes to be recorded in the same accounting period.
Examples of a Bad Debt Expense
To further clarify, here are a couple of examples of bad debt expenses, including sample calculations.
You're in your first year of business. You currently use the direct write-off method for recording bad debt expenses. At the end of the year, you're left with $1,500 in outstanding accounts, which you don't anticipate being able to collect on. You take the $1,500 from the amount of accounts receivable and move it to your bad debt expense account.
You're in your third year of business. By now, you know that some clients will inevitably not pay you. You've set a bad debt expense allowance of $3,000 for the year. By year's end, you have $1,500 in unpaid invoices. Thus, you have a debit of $1,500 in your allowance for your bad debt reserve account.
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Notice to the Reader
The content within this article is meant to be used as general guidelines. The appropriate means of estimating and calculating your bad debt expense depends on your precise business model. Always consult with a professional accountant to ensure you're meeting accounting standards.