Learn what bad debt expense is, how to calculate it using proven methods, and why accurate estimation protects your financial statements.
Learn what bad debt expense is, how to calculate it using proven methods, and why accurate estimation protects your financial statements.
Your sales team closed a massive deal last quarter. Revenue is booming. The customer is a solid adopter, an advocate even.
But then six months later, that invoice still sits unpaid. And now it’s more than likely it won't get paid.
But you already booked the revenue. Recorded the sale. But the cash you actually collected? That's not a bad debt expense.
And for any business extending credit to customers, it's not a matter of if some accounts go bad. It's a matter of how many and how accurately you're accounting for them.
Bad debt expenses represent the portion of AR (accounts receivable) a company estimates it won't be able to collect.
It represents an account reality: Not every sale converts to cash.
And before write-offs happen, your financial statement needs to reflect that.
Specifically, for companies selling on credit (which- let's be honest, is alot of B2B and Service firms) understanding bad debt expense is essential.
It directly affects
All of which drive real, actionable business decisions.
Let’s read on to learn more about what Bad Debt is and how you can ensure the best practices surrounding it.
Bad debt expense is necessary because of a very simple accounting rule: the matching principle. When you use the accrual principle of accounting, you recognize revenues in the period they are earned, not in the period they are received in cash.
Thus, if you are showing income in your income statement on the basis of money that you will never get, the statement is not accurate. Bad debt expense eliminates this problem in the income statement.
Here's what proper bad debt accounting accomplishes:
Correct reporting of income.
Net income is overstated without the deduction of the bad debt expense. You are counting chicks that are not just “unhatched” but never will be “hatched.”
Realistic asset valuation.
The amount in the accounts receivable section in the balance sheet must also equal what is going to be realized. This is accomplished through an allowance for doubtful accounts.
Compliance with GAAP and IFRS.
Both GAAP and IFRS address the measurement of uncollectible accounts, rather than waiting for an account to be actually Worthless. IP and direct write-off methods of tracking uncollectible accounts are not acceptable under generally accepted accounting principles.
Improved decision-making.
When leadership looks at financial reports, they require numbers to accurately reflect what’s really going on. Inflated amounts for accounts receivable and income skew a financial situation, causing leaders to make decisions on capital expenditures, turnover, or expansion too soon.
There are actually two methods for recording bad debt expense.
Well, technically.
One is preferred under GAAP.
The other one… exists.
Let’s take a peek at both:
The allowance method estimates bad debt expense before specific accounts go bad. It creates an ‘allowance for doubtful accounts, ’ a contra asset that reduces the reported value of accounts receivable.
How it works:
Think of it as a holding space or a reserve for anticipated losses. You don't know which customers will default yet, but history tells you some will—so you reserve against that reality now.
Journal entry to record estimated bad debt expense:
This method aligns with accrual accounting and the matching principle. The expense hits the income statement in the same period as the revenue it relates to—even if the actual write-off happens months later.
This one is a bit more dicey of the two.
The Direct Write-off Method requires that the bad debt expense be recorded solely on the determination that a particular account will not be collected. No estimation is required nor an allowance account.
This is simply a write-off after you have lost all hope. This is as if you have thrown the money away and moved on without even considering the possibility that it might be given to you.
Journal entry under direct write-off:
The issue is this: this accounting method breaks the matching principle. You could recognize revenue in January and defer the corresponding bad debt expense until October, or next year.
The income statement for that year won’t show the true cost of recognizing that revenue.
The direct write-off method does not comply with the accounting principles of businesses with large receivables. However, it qualifies as acceptable accounting treatment with respect to taxes and small businesses in instances where bad debts may be deemed to be immaterial and unpredictable.
There are two primary ways to calculate bad Debt
The right choice is really all about your business model, customer base, and collections process.
This approach estimates bad debt as a fixed percentage of credit sales for the period. It's straightforward and works well for businesses with consistent collection patterns.
Formula:
Bad Debt Expense = Credit Sales × Estimated Uncollectible Percentage
Example:
A company has $500,000 in credit sales this quarter. Historical data shows approximately 2% of credit sales become uncollectible.
Bad Debt Expense = $500,000 × 2% = $10,000
The percentage-of-sales method is focused on the income statement and directly calculates the expense each period. It is easy to use, but it doesn’t consider the makeup of your receivables at a point in time.
The aging process determines the current status of the accounts receivable by the age of the invoices. The older the invoices, the higher the uncollectible percentages assigned to the invoices because the older the invoices, the less likely they are to be collected.
Example aging schedule:
With this approach, you determine the ending balance required in the allowance for doubtful accounts. The bad debt expense for the year is the amount of additional allowance required to reach the calculated ending balance.
For instance, if the current balance of the allowance is $8,000, but the aging analysis indicates that the balance should be $21,750, then the bad debt expense would be recorded as $13,750.
The aging method is more accurate because it is a true reflection of the quality of the receivables that you have in your portfolio. Those organizations that have a wide customer base and a heavy receivables volume usually opt for this method.
Writing Off an Uncollectible Account
Writing off bad debt expense and charging off a particular account are two different actions—and many people get them confused.
Bad debt expense is the estimate. You’re making the entry based on the estimate you make for the future uncollectible items based on past experience or analysis of the receivables.
A write-off occurs when you determine a certain account is uncollectible. The customer has gone bankrupt, hasn’t been responding, or you have exhausted your options.
When using the allowance method, the write-off of the account does not affect the income statement. This is because you previously recorded the expense in setting up the allowance account. The write-off reduces the receivable and the corresponding allowance.
Journal entry to write off a specific account:
Notice that bad debt expense is not affected. The effect on the income statement has already occurred when the allowance was established. It is the matching principle at work—the expense was recorded in the same period that the income was realized, not in the period of the write-off.
If the allowance balance falls below what is expected because of additional write-offs, you would record additional bad debt expense to increase it to a proper level.
Bad debt expense ripples through all three primary financial statements. Understanding these connections matters for anyone interpreting financial results or making decisions based on them.
Bad debt expense appears as an operating expense, reducing net income. For companies with significant credit sales, this can be a material line item. It directly affects profitability metrics and, for public companies, earnings per share.
Here's the reality: companies that underestimate bad debt expense report higher profits than they've actually earned. This might look good in the short term, but it catches up when write-offs exceed the allowance and additional expense must be recognized.
The allowance for doubtful accounts reduces the gross accounts receivable balance to its net realizable value. This is the amount the company actually expects to collect.
Presentation example:
Accounts Receivable (gross): $500,000
Less: Allowance for Doubtful Accounts: ($15,000)
Accounts Receivable (net): $485,000
This relationship is carefully examined by analysts and lenders. A situation where the receivables are high and the allowance is very small can be indicative of the company’s understatement of bad debt exposure. A situation where the allowance is disproportionately high in relation to the receivables can be indicative of difficulties in collecting the receivables or of overly cautious accounting.
Bad debt expense is an item that is not in cash. When using the indirect method, this item is added back to net income.
This introduces a significant point of differentiation: bad debt expense reduces income but does not reduce cash flow in the same year the expense is recorded. This effect occurred in the previous year when the sale occurred, generating the receivable. This expense recognition simply recognizes that some of that cash flow isn't realized.
For cash flow management purposes, tracking actual collections versus booked receivables matters more than the bad debt expense itself.
The truth is, bad debt expense can quickly become an afterthought—a simple matter of making the entry and adjusting the allowance before moving on.
Check Your Credit Policy
Your allowance percentage can be thought of as a credit policy scorecard. When bad debt at 5% of receivables and industry standards are at 2%, it's more of a credit policy problem than an accounting problem.
Use Bad Debt as an Indicator
What you might find by tracking the trend of the allowance needed is that it does reveal an important trend. The increase in estimates from one quarter to the next could mean economic trouble for your customers before anything else indicates it.
Use Bad Debt as a Forecast
If you always underestimate the bad debt expenses, it means you are overreporting income. If you overestimate, it means you are being too conservative, which might mean you are hiding some reserves in the income statement, which auditors might not find pleasant.
This is where accounts receivable management meets bad debt accounting. The objective is not simply to accurately report expenses but to mitigate the amount of bad debts to be provided.
How Financial Leadership Leads the Charge on Bad Debt
It is likely that most accounting departments are capable of dealing with the technicalities of bad debt expense. The accounting entries are not complicated.
The calculations are not intricate.
However, it is the estimates that call for experience.
Where do you place the percentages on each bucket of aging, and how do you make adjustments based on changes in economic conditions?
When does a customer’s slow payment become a credit issue, requiring a more substantial allowance, especially if it is a big customer?
These are the kinds of decisions that drive the story that your stakeholders see—and they can impact earnings, values, and the financial story.
Get them wrong, and you can find yourself exaggerating earnings or bringing them down unnecessarily.
This is exactly where the value of having a fractional CFO lies.
Not to record the entries, which is your accounting department’s job, but to establish the policies, verify the estimates, and make sure that the method of calculation of allowances actually mirrors your company’s realities.
For companies dealing with customer concentration risk, economic uncertainty, or growth outpacing the ability of the finance organization, having experienced financial leaders assess these estimates is the greatest risk management you can have.
Ready to improve your financial reporting and receivable management functions?
Let’s talk about how a fractional CFO can help provide the financial leadership your company needs without the overhead of a full-time employee.
It's the estimated portion of the accounts receivable that a business expects it will not be able to collect. It's recorded as an operating expense in order to match the uncollectible accounts with their revenue in accordance with the accounting matching principle.
There are two main approaches to this problem. In the percentage of sales method, the credit sales are multiplied by a historical rate of uncollectibility. In the aging of accounts receivable method, the analyst looks at the age of the receivables and uses a higher rate of uncollectibility for the older receivables. The latter is more accurate.
Bad debt expense is an operating expense account. It appears on the income statement and reduces net income. The corresponding credit goes to the allowance for doubtful accounts—a contra asset account that reduces accounts receivable on the balance sheet.
Bad debt expense is an estimate made before a specific account becomes a bad account, and a write-off eliminates a specific bad account from the records of a company. The write-off of a bad account in the allowance method of accounting does not generate additional expense, as it merely offsets both the accounts receivable and the allowance account.
.svg)
.svg){kind=icon}