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.
Unpaid receivables like these become bad debt expense and will need to be recognized on the income statement, to reflect the loss the company experienced. The amount of bad debt expense record is contingent on US GAAP.
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.
Learning how to calculate bad debt expense can be handled a couple of different ways. The first is the allowance method which simply credits the potential income in accounts receivable. Since accounts receivable is part of the balance sheet, it does not affect the income statement. Instead, a debit is made under the allowance for doubtful accounts category, and a credit is issued to Accounts Receivable.
The allowance for doubtful accounts helps to estimate the income a company believes it will receive. It is considered a contra-asset account, and is only used by companies that allow customers credit for payment of goods and services. The account must reflect the same accounting period in which a particular sale was made and can be adjusted depending on the amount left in the account.
The allowance for doubtful accounts can be estimated by applying a flat percentage rate to sales or by using historical aging data. Under the first process, also known as the sales method, a company that grosses $100,000 in a reporting period could estimate that three percent of their total sales will not be collected. Therefore, an allowance for doubtful accounts would be established with a balance of $3,000.
Using the aging method, all unpaid debts are categorized by time periods. For example, a company divides debts by 30 days outstanding and 60 days outstanding. By reviewing historical data, a company could determine that two percent of accounts 30 days old or less are typically unpaid, and five percent of accounts 60 days or older go unpaid. The company would report an allowance for doubtful accounts that is the total expected unpaid debt amounts for both categorized periods.
The second method for calculating bad debt expense is to use a simple direct write-off. To determine how much should be written-off, a company would take the real number of uncollected debts and divide by the total accounts receivable during that period to obtain a percentage rate. This rate would show the percentage of bad debt.
The accuracy of bad debts in accounts receivable is a bit tricky. Companies cannot be certain that a debt will never be paid. Therefore, they have to estimate what they believe will be uncollected debt based on past collection data. The longer a company is in business the more accurate the bad debts expense estimation can be because there is a longer aggregate history to consider.
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.
For companies that choose not to establish a bad debt allowance which allows a journal entry to write-off worthless debt, there could be real consequences. Many business owners and managers have a difficult time believing a client won’t pay their invoice. Unfortunately, even customers who have a wonderful payment history could encounter a problem which prevents them from being able to pay, and companies must be prepared to withstand these bad debts. Failing to create a bad debts allowance, especially when revenue is growing, will have a direct affect on financial planning efforts. Managers could end up with less money than projected and find themselves unable to meet their own obligations. The omission of the bad debt allowance can also prevent management from having a true understanding of the financial health of the company.
Using financial statements 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 credit 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.