What is Bad Debt Expense?

A bad debt expense refers to a portion of a company's accounts receivable that can no longer be collected. A company's accounts receivable refers to debts that its customers owe, it is the amount for goods sold but are yet to be paid by customers. When a company experiences a bad debt expense, it means that an account receivable is no longer collectible due to default on payment by a customer. A customer might default on payment for credit if he is bankrupt or faced with other financial hardships. A bad debt expense can be reported in a company's financial statements under the provision for credit losses.

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How to Account for a Bad Debt Expense

Doubtful accounts expense resulting from a customers bed debt can be included in a company's financial statement. Bad debt expenses are uncollectible accounts of insolvent customers who owe a company money for goods sold or services rendered. Expenses of this nature are recorded as sales and general administrative expenses which are included in a company's income statement. Records of bad debts expenses by a company will lead to a reduction in the accounts receivable that the company has on the balance sheet.

Direct Write-Off vs. Allowance Method

When using the provision for credit losses when compiling a company's financial statements, two distinct methods can be used. These are the direct write-off method and the allowance method. In the U.S, the direct write-off method is used for income tax purposes, in this situation, a company's uncollectible accounts are written off. The allowance method on the other hand, estimates the uncollectible accounts in dollars in the same accounting period in which the revenue is earned. This means that the estimated dollar amount of uncollectible accounts is charged to a reserve account when sales are made. The failure of the direct write-off method to meet the accrual accounting standards and GAAP enrolled the allowance method as a better way of recognizing credit losses.

Calculating Bad Debt Expense Using Allowance Method

Allowance method of calculating bad debt expense is done based on an estimated figure. The estimated dollar amount of uncollectible accounts and the period of sales in the company are important. Using the allowance method, a company with a bad debt expense is required to debit the bad expense and credit this allowance. The probability of default of customers on accounts receivable can be used for the estimation of expected losses that will result from bad debts. Delinquent debts history of the company can also be used. In a similar vein, the estimation of a company's bad debt can be done based on the percentage of net sales and past experience with bad debts.