Bad Debt Expense

Bad debt refers to loans or credit sales that the business determines can no longer be collected. To account properly for bad debt, the business must record it as an expense.

Almost all businesses make a percentage of sales on credit, which means that the customer does not pay the full amount at the point of the transaction. Many businesses also extend loans to their customers.

Loans and credit build trust and goodwill with customers and help the business expand its customer base.

All credit sales and loans come with a risk, which the business accepts. Businesses have policies and procedures for evaluating customers’ creditworthiness and for setting the terms under which credit will be extended.

However, even with the best policies and guidelines in place, some customers still default. Businesses accept this risk and account for it according to the Generally Accepted Accounting Principles (GAAP).

Bad debt is considered an expense which offsets assets in business’s accounts receivable, also known as the net realizable value of the accounts receivable.

The expense is recorded according to the matching principle so that accounts receivable assets are not overstated.

Accounts receivable record purchases and transactions that have not yet been paid for by the customer. They are considered an asset because they are a financial resource that can be converted to cash in the near future, once the customer has paid.

Accounts receivable are typically collected in two months or less. For this reason, they are considered a “short-term asset” which refers to any financial resource that can be converted to cash in one year or less.

Bad debt offsets this asset because it is an accounts receivable that will not be collected. According to the matching principle, expenses must be matched to related revenues in the same accounting period.

Because a business does not typically know that an account receivable will not be collected until sometime later, it will instead estimate how much bad debt will occur.
The business can estimate bad debt in one of two ways:

Bad debt can be recorded according to the direct write-off method. In this method, accounts are written off as a loss once they are determined to be uncollectible. Because this method does not adhere to the matching principle, it is a less acceptable accounting method.

To remain consistent with the matching principle, businesses will write-off bad debt according to the allowance method. According to this method, the business will set aside a reserve for expected bad debts, or so-called doubtful accounts. This reserve, or allowance, is also referred to as a contra asset account because it “nets” or balances against the accounts receivable assets listed in the balance sheet.

The allowance is calculated based on an estimate of how many accounts receivable might not be collectible. The estimate is calculated as a percentage of sales multiplied by a historical average of accounts receivable that have gone uncollected.

Although it is based on an estimate, this method allows a business to align bad debt to the reporting period in which the sale occurs. This is in accordance with the matching principle, and therefore, it is considered a more accurate form of accounting bad debt expenses.

If bad debt is later collected, it is recorded as a bad debt recovery.