What is Bad Debt Expense & How to Calculate It ?

Bad debt expense is a specific expense account that a business recognizes when its customers are unable to make the necessary payments on their accounts receivables or, in other words, on their debts owed to the business. It is added to a company’s expenses and directly lowers a company’s net income/profit after accounting for uncollectible accounts receivables.

The bad debt expense is not the cash flow out of the business, as it reflects the loss incurred by the business. It can therefore be described as an accounting entry outlining the expected value of receivables Customers will be unable to pay in full.

This expense on the other hand reduces the taxable income for the reporting period in which it is recorded, but the actual write-off of a bad debt is done after every available legal remedy of collection has been exercised and there is no possibility of recovering the account receivable.

Why is the Recognition of Bad Debt Expense Important?

Business entities that trade on credit have a trade receivables account since they record the credit sales they make to customers. This is or contains all the open or unpaid invoices and outstanding monies owed to the company by customers and clients.

Thus, while most customers will clear their dues in the long run, there will always be outstanding invoices, which cannot be recovered regardless of the number of times they are chased. The amount of money that is not considered to be collectible has to be reflected by increasing the value of receivables and writing it off as a bad debt.

This expense has two main responsibilities:

1. It provides a better picture of the value of accounts receivable by providing for non-recoverable debts.

2. It helps the business to offset a tax based on the probable loss of the amount of bad debt in the course of the period under consideration. This in turn helps in the reduction of the amount of taxable income that is subjected to taxes and therefore assists in controlling tax costs.

So, while it wipes out cash profits through non-payment, bad debt expense makes sure it does not appear as overly inflated profits in the financial statements and books of accounts. It is correct to align the revenues of the period with the costs incurred during that period.

Techniques or Approaches to Predicting Bad Debts

There are two primary ways companies can estimate and recognize bad debt expenses:

1. The Percentage-of-Sales Method

2. The Aging Method

Let's explore both of these methods in detail:

1. Percentage-of-Sales Method

This technique of accounting for bad debts involves estimating the amount for the total net credit sales done within a certain period. In this method, the company estimates the percentage of the revenues that cannot be collected, and the amount is then deducted as bad debts.

For example, assume that a company sells on credit with net credit sales of $1 million for 2022 and that 2% of the total credit sales have always been bad debts. In this way, the company will look like this:

Net Credit Sales= $ 1,00,000
Est. Uncollectible Percentage = 2%

Bad Debt Expense = Cost of goods sold x percentage: $1,000,000 x 2% = $20,000

This approach is very simple and is therefore the major advantage when using this method. Recording the bad debt amount is possible using only one calculation based on the sales revenue. However, the absence of aging of receivables and any special bad debt problem is the major weakness in the case.

2. Aging Method

The aging method also known as the allowance method is a more refined approach to estimating the uncollectible accounts based on the evaluation of the existing accounts receivable.

In this method, the companies split the total outstanding receivables into various groups concerning the number of days for which the receivables are due from the customers. For example:

1. 0-60 days
2. 61-90 days
3. 91-180 days
4. Over 180 days

As with uncollectable percentages, aging allows applying non-payment ratios and tendencies observed in history to every age bucket. The older the outstanding invoices, the higher the uncollectible provisions will be.

Allow me to give you an example of how it works –

The analysis of the total amount of accounts receivables is: Total Accounts Receivables = $ 500,000

Age Brackets --- Concept for Uncollectible % --- Provision Total
Number of patients enrolled in the study 0-60 days —– 1% —– $ 3000
61-90 days — 5 percent — $8,000
If delivery takes 91-120 days then the discount is 20% which translates to $12,000.
More than 120 days but less than 180 days – 60% — 18,000

Total Bad Debt Expense = $41000

As can be observed, the aging analysis takes into account the age of receivables as well as actual balances in accounts receivable. This assists business organizations in properly aligning the measurement of the expected credit losses with the appropriate bad debt expenses.

Writing Off Bad Debts and Including in the Accounting of Expenses

Once the potential amount of debts that have gone bad has been determined by any of the above methods, the journal entry to place it on the books would be –

Bad Debt Expense Dr
Accounts Receivable Cr

This, in effect, charges the receivables asset account and debits the bad debt income statement account under the operating expense of the period.

The key thing to understand here is that this entry does not adjust the provision in books of account but only through provisioning. There is no ‘write-off’ of any customer account at this stage.

Conclusion

Bad debt expense is one more problem that has been recognized only as a threat to profitability and working capital for companies having credit sales. It is normal for some amount to be non-paid, but when this amount is estimated reliably, then financial statements for companies would be more reliable.

When both percentage-of-sales and aging methods are used appropriately, a business estimates the right amount of credit losses from uncollectible amounts and relates it directly to the revenues of a specific period. It also leads to tax cuts due to low income as highlighted above also applies to this process. Last but not least is the act of recognizing bad debts before they occur, which proactively manages cash flows by putting in place provisions for the expected losses.

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