When a company sells products and services, it may do so by extending credit to its clients. When a company produces products or services for customers and issues invoices for payment of those products or services, it is reasonable to assume that many of those invoices will not be paid. As a result, an accounts receivable is created and left open, until the money is collected. If the money is never collected and the client defaults on their obligation, then the receivable needs to be removed the balance sheet.
How to Calculate the Bad Debt Expense Formula
When a business is owed money, and clients fail to pay, there are losses that need to be recognized on the income statement. Bad debt expense is recorded using a technical accounting method, such as the direct write-off method or the allowance method. Selecting the right method, and making the right calculation, impacts the relevance and accuracy of a company’s financial statements.
Factors Impacting Bad Debt
There is a myriad of factors that can change the likelihood and volume of bad debt. For example, severe economic downturns can give rise to higher default rates and uncollectible accounts receivable. Other factors include loose lending criteria, industry specific crises and customer dissatisfaction. Forecasting bad debt volumes is a process that auditors and business owners both care about, making it important for accountants, analysts and business leaders to make accurate predictions.
Preparing Bad Debt Expense Journal Entry
When preparing a bad debt journal entry, it is important to have the bad debt schedule and write-off policy as supporting documentation. The journal entry requires the reduction of accounts receivable and the recognition of bad debt expense on the income statement. The type of journal entry created, and support used varies between the direct write-off method and the allowance method. Expect to have this journal entry audited during financial examinations.
Examples of Bad Debt Expense
When a company has accounts receivable, and some of the accounts are uncollectible, bad debt expense is recognized and recorded in the proper amount. The bad debt can result from defaults on notes receivable, trade receivables arising through the normal course of business or another type of receivable. The direct write-off method allows for a straightforward calculation and write-off of bad debt. The allowance method, however, is more complicated to record.
Bad debt expense is a widely monitored metric in the mortgage industry. Given that defaults on mortgages gave rise to one of the worst financial crises in U.S. history, the allowance for bad debt is something that regulators and investors focus on. It is important to accurately forecast bad debt and prepare for it from a cash flow perspective, to protect the health of a business.
Calculating bad debt expense accurately is of the utmost importance to users of financial statements. Selecting the right calculation method, and maintaining accurate supporting schedules, requires skill, vigilance and dedication. Working with trained accountants is critical for recording bad debt accurately.
Using as a monitoring tool, a business may find their bad debt expenses are higher than normal and becoming problematic, it could be time to review policies on extending to clients. An evaluation of these procedures could make a tremendous difference in the bottom line of a company in a very short period of time.