Bad Debt Expense

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Bad Debt Expense

Key takeaways

  • Bad debt expense recognizes receivables a company does not expect to collect.
  • GAAP requires the allowance method (matching principle); the direct write-off method is often used for U.S. tax purposes but can distort matching.
  • Two common estimation approaches are the percentage of sales and accounts receivable aging methods.
  • The allowance for doubtful accounts is a contra‑asset that reduces reported accounts receivable on the balance sheet; bad debt expense appears on the income statement (usually under SG&A).

What is bad debt expense?

When a company makes a credit sale, it records revenue and an accounts receivable. Because some customers will not pay (for reasons such as bankruptcy or financial distress), companies must recognize an estimate of uncollectible receivables. That estimated amount is recorded as bad debt expense and reduces net income for the period in which the related revenue was recognized.

How bad debt is recorded

Two main approaches are used:

Direct write-off method
* Records the exact uncollectible receivable as an expense when a specific account is determined to be uncollectible.
* Journal entry when an account is written off:
* Debit: Bad Debt Expense
* Credit: Accounts Receivable
* Simple, but it violates the matching principle and can distort financial results; commonly used for tax purposes in the U.S.

Allowance method (preferred under GAAP)
* Estimates uncollectible amounts in the same period as the related sales.
* Establishes an allowance for doubtful accounts (a contra‑asset) that reduces gross accounts receivable.
* Initial journal entry:
* Debit: Bad Debt Expense
* Credit: Allowance for Doubtful Accounts
* When a specific receivable is written off later:
* Debit: Allowance for Doubtful Accounts
* Credit: Accounts Receivable

Estimating bad debt

Common estimation methods:

  1. Percentage of sales (income statement approach)
  2. Apply a historical percentage to current period net sales.

  3. Example: If historical bad debts are 3% and net sales are $100,000 → bad debt expense = $3,000.

  4. Accounts receivable aging (balance sheet approach)

  5. Group receivables by age and apply increasing default percentages for older balances.
  6. Example: $70,000 of receivables <30 days (1% uncollectible) and $30,000 ≥30 days (4% uncollectible) → allowance = (70,000×1%) + (30,000×4%) = $1,900.

  7. If the existing allowance balance differs from the newly estimated allowance, record bad debt expense equal to the difference.

  8. Statistical and predictive models

  9. Use historical default rates, customer credit scores, macroeconomic data, or probability-of-default models to estimate expected credit losses.
  10. Models should be updated regularly to reflect current experience and economic conditions.

Where bad debt appears in the financial statements

  • Income statement: Bad debt expense is typically reported within selling, general, and administrative expenses (SG&A).
  • Balance sheet: Allowance for doubtful accounts is a contra‑asset that reduces gross accounts receivable, reporting net receivables.

Practical example (summary)

A company reports $32.89 billion of net accounts receivable after offsetting an allowance of $1.1 billion. The allowance reflects management’s estimate of receivables not expected to be collected. Year‑to‑year changes in the allowance are reflected through bad debt expense; a large increase in the allowance would result in a significant bad debt expense in that period.

Why it matters

Recognizing bad debt accurately:
* Ensures revenues and related expenses are reported in the same period (matching principle).
* Prevents overstatement of assets and income.
* Provides more reliable financial information for decision making, lending, and valuation.

Bottom line

Bad debt expense is an inherent cost of extending credit. The allowance method—using percentage of sales, aging, or statistical models—is the preferred way to estimate and recognize expected credit losses so financial statements reflect a realistic view of collectible receivables.