Bad Debt Expense

Bad Debt Expense is an amount of uncollectible receivable that appears on an income statement as an expense.

Mostly, companies make sales on credit which increase the possibility of having bad debt. This is because there are chances that the debtor or borrower might default on payments due to any reason. The amount that can not be collected is a loss of revenue for the company as it decreases the assets and increases liabilities. This lowers the company's net income which results in reduction of stockholders' equity. It is estimated and recorded periodically as bad debt expense.

Determining bad debt expense :

There are two methods, through which bad debt can be recoded.

1. The Direct write-off method- an amount of uncollectible receivable is charged directly to the income statement. That means that a company records bad debt expense when it actually collects the revenue in the form of cash and then realizes this uncollectible amount. This method is not appreciated as it doesn't conform to the matching principle of costs to revenue.
2. The allowance method - This method follows the matching principle of accounting which states that revenues and expenditures have to be recorded in the same accounting period in which they are incurring.

When a sale is recorded, the amount receivable is recorded at a net realizable value. Net realizable value is the amount that gets converted into cash. There is risk of not getting paid the entire amount from the clients. So the amount which can not be collected is estimated and recorded on the balance sheet as Allowance for doubtful accounts. This is a contra-asset account associated with the balance in accounts receivable. Estimation is done on the basis of past records and considering clients credit credentials.

Then the amount of uncollectible receivable is written off as an expense from Allowance for Doubtful Accounts to the account called Bad Debt Expense. Thus, bad debt expense is also recorded at the time of the sales, instead of waiting till the amount is realized as uncollectible. Here, both revenues and expenses are recorded and when they occur, it satisfies the matching principle.

When the real amount of uncollectible receivables is determined, adjustments are made to the allowance account by increasing or decreasing the allowance as necessary.

Estimating bad debt expense :
There are several methods to estimate bad debt. Various companies use different methods to calculate bad debt expense. Some of them are

• Aging method- Some companies estimate bad debt expense by the aging method. It is considered that the longer the period of time the debt is unpaid, the lesser the possibility to collect it.
• Percentage of credit sale method - Some companies uses a % of gross credit sales to estimate the bad debt expense. For example, if the gross credit sale is $100,000 and 1% of credit sale is anticipated uncollectible, then the estimated bad credit expense will be $ 1,000(1% of $100,000).
• Percentage of total accounts receivable method - Some companies estimate the bad debt expense by taking a percentage of accounts receivable balance.

Bad debt, occurring by whatever reasons either by extended credit terms or the client being defaulter, should be handled carefully. You should be aware of the current economic conditions while making an estimate for bad credit expense.