Bad Debt Expense Definition and Methods for Estimating

What Is a Bad Debt Expense?

A bad debt expense is recognized when a receivable is no longer collectible because a customer is unable to fulfill their obligation to pay an outstanding debt due to bankruptcy or other financial problems. Companies that extend credit to their customers report bad debts as an allowance for doubtful accounts on the balance sheet, which is also known as a provision for credit losses.

Understanding Bad Debt Expense

When a company makes a credit sale, it books a credit to revenue and a debit to an account receivable. The problem with this accounts receivable balance is there is no guarantee the company will collect the payment. For many different reasons, a company may be entitled to receiving money for a credit sale but may never actually receive those funds.

Because the company may not actually receive all accounts receivable amounts, Accounting rules requires a company to estimate the amount it may not be able to collect. This amount must then be recorded as a reduction against net income because, even though revenue had been booked, it never materialized into cash.

This expense is called bad debt expenses, and they are generally classified as sales and general administrative expense. Though part of an entry for bad debt expense resides on the balance sheet, bad debt expense is posted to the income statement. Recognizing bad debts leads to an offsetting reduction to accounts receivable on the balance sheet—though businesses retain the right to collect funds should the circumstances change.

How to Calculate Bad Debt Expense

There are two different methods used to recognize bad debt expense. Using the direct write-off method, uncollectible accounts are written off directly to expense as they become uncollectible. On the other hand, the allowance method accrues an estimate that gets continually revised.

Direct Write-Off Method

The direct write-off method is used in the U.S. for income tax purposes. However, while the direct write-off method records the exact amount of uncollectible accounts, it fails to uphold the matching principle used in accrual accounting and generally accepted accounting principles (GAAP). The matching principle requires that expenses be matched to related revenues in the same accounting period in which the revenue transaction occurs.

The major problem with the direct write-off is the unpredictability of when the expense may occur. Consider a company that has a single customer that has a material amount of pending accounts receivable. Under the direct write-off method, 100% of the expense would be recognized not only during a period that can't be predicted but also not during the period of the sale.

The entries to post bad debt using the direct write-off method result in a debit to 'Bad Debt Expense' and a credit to 'Accounts Receivable'. There is no allowance, and only one entry needs to be posted for the entry receivable to be written off.

Allowance Method

The allowance method is an accounting technique that enables companies to take anticipated losses into consideration in its financial statements to limit overstatement of potential income. To avoid an account overstatement, a company will estimate how much of its receivables from current period sales that it expects will be delinquent.

Because no significant period of time has passed since the sale, a company does not know which exact accounts receivable will be paid and which will default. So, an allowance for doubtful accounts is established based on an anticipated, estimated figure.

A company will debit bad debts expense and credit this allowance account. The allowance for doubtful accounts is a contra-asset account that nets against accounts receivable, which means that it reduces the total value of receivables when both balances are listed on the balance sheet. This allowance can accumulate across accounting periods and may be adjusted based on the balance in the account.

How to Estimate Bad Debt Expense

Two primary methods exist for estimating the dollar amount of accounts receivables not expected to be collected. Bad debt expense can be estimated using statistical modeling such as default probability to determine its expected losses to delinquent and bad debt. The statistical calculations can utilize historical data from the business as well as from the industry as a whole. The specific percentage will typically increase as the age of the receivable increases, to reflect increasing default risk and decreasing collectibility.

Alternatively, a bad debt expense can be estimated by taking a percentage of net sales, based on the company’s historical experience with bad debt. Companies regularly make changes to the allowance for credit losses entry, so that they correspond with the current statistical modeling allowances.

Accounts Receivable Aging Method

The aging method groups all outstanding accounts receivable by age, and specific percentages are applied to each group. The aggregate of all groups' results is the estimated uncollectible amount. For example, a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding.

Based on previous experience, 1% of accounts receivable less than 30 days old will not be collectible and 4% of accounts receivable at least 30 days old will be uncollectible. Therefore, the company will report an allowance and bad debt expense of $1,900 (($70,000 * 1%) + ($30,000 * 4%)). If the next accounting period results in an estimated allowance of $2,500 based on outstanding accounts receivable, only $600 ($2,500 - $1,900) will be the bad debt expense in the second period.

Percentage of Sales Method

The sales method applies a flat percentage to the total dollar amount of sales for the period. For example, based on previous experience, a company may expect that 3% of net sales are not collectible. If the total net sales for the period is $100,000, the company establishes an allowance for doubtful accounts for $3,000 while simultaneously reporting $3,000 in bad debt expense.

If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $2,400 is recorded in the second period in bad debt expense. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400.

Example of Bad Debt Expense

As part of its 2021 annual report, Amazon reported details in its notes to the financial statements regarding accounts receivables, allowance for doubtful accounts, and bad debt expense. Although bad debt expense is not explicitly called out in its financial statements, assumptions can be made based on footnote disclosures about their allowance estimates.

From the financial statement snippet above, the important words to note is "net and other". This means that the gross amount of accounts receivable have been reduced. Instead of showing the gross accounts receivable and an offsetting allowance for doubtful accounts, Amazon has combined these two amounts. At the end of 2021, Amazon reported $32.89 billion of accounts receivable.

More information about this balance is disclosed in the notes below.

Based on the note disclosure, Amazon's allowance for doubtful accounts is $1.1 billion. This means the gross amount of accounts receivable is actually over $1 billion higher than what the company is showing on its financial statements. However, due to conservatism, this balance has been reduced.

In addition, it's important to note the change in the allowance from one year to the next. Because the allowance went relatively unchanged at $1.1 billion in both 2020 and 2021, the entry to bad debt expense would not have been material. However, the jump from $718 million in 2019 to $1.1 billion in 2022 would have resulted in a roughly $400 million bad debt expense to reconcile the allowance to its new estimate.

The Bottom Line

Bad debt expense is a natural part of any business that extends credit to its customers. Because a small portion of customers will likely end up not being able to pay their bills, a portion of sales or accounts receivable must be ear-marked as bad debt. This small balance is most often estimated and accrued using an allowance account that reduces accounts receivable, though a direct write-off method (which is not allowed under GAAP) may also be used.