Bad Debt Expense: What is it and How to Calculate

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. Unpaid receivables like these become bad debt expense and will need to be addressed.
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.
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.