When a business finds itself unable to recover money it is owed from its customers for goods or services already provided, that amount is known as bad debt. It’s not an ideal situation, but it has to be faced, and by accurately accounting for bad debts, you can mitigate their effects as much as possible.
In this article, we will cover the definition of bad debt, methods for calculating bad debt expense, the impact of bad debt on financial statements, and best practices for managing credit.
Also, this guide is related to our articles on understanding gross vs. net profit, understanding and calculating EBITDA, and operating income vs EBITDA.
This list includes:
– Bad debt expense calculation
– Direct write-off method
– Allowance method advantages
– Recovering bad debts procedures
Let’s get into it!
Understanding bad debts
Bad debt is the amount of money that a business is unable to recover from its customers or clients who have defaulted on their payments. This results in a loss for the business as the revenue from the sale or service provided is not realized.
What’s the difference between bad debt and doubtful debt?
While bad debt represents the total loss on an account that is highly unlikely to be recovered, doubtful debt refers to accounts where there is uncertainty regarding the collection of payment. Businesses classify doubtful debts under a separate category to account for potential losses, while bad debts are written off as a complete loss.
Methods for calculating bad debt expense
There are several ways to work out bad debt expenses–let’s walk through some of the most-used ones.
Direct write-off method
The direct write-off method is a simple way to account for bad debt. When a business determines that a specific customer’s account is uncollectible, the outstanding balance is directly written off as a bad debt expense. This method is straightforward but may not accurately reflect the true financial position of the business as bad debts are only recognized when they occur.
Here’s how to use the direct write-off method:
- Identify the specific customer accounts that are deemed uncollectible.
- Write off the outstanding balance of those accounts as bad debt expense.
- Record the journal entry to reflect the bad debt expense and reduce the accounts receivable.
Allowance method
The allowance method is a more conservative–and preventative–approach to accounting for bad debts. Instead of waiting for individual accounts to become uncollectible, businesses estimate and set aside a provision for bad debts based on historical data and industry trends. This allowance for doubtful accounts reduces the accounts receivable to reflect the probable amount that will not be collected.
Advantages of allowance over direct write-off
- Provides a more accurate representation of your financial position by recognizing bad debts before they occur.
- Matches expenses with revenues, following the matching principle of accounting.
- Helps in forecasting and budgeting by estimating the potential losses from bad debts in advance.
- Improves the reliability of financial statements by presenting a more realistic picture of your business’s financial health.
Allowance method in detail
The allowance method certainly has advantages, but how does it actually work and what steps do you need to take to use it?
Setting up an allowance for doubtful accounts
To start with, you’ll need to set up an allowance for doubtful accounts, aka customers who may not pay their invoices. First, analyze your past data on bad debt. Look at how much of your accounts receivable in the past has not been collected. Based on this historical data, you can then calculate a percentage that represents the likelihood of customers not paying.
Here are two ways you might choose to calculate that percentage.
Percentage of sales method: how to calculate based on historical data
One common method for calculating the allowance for doubtful accounts is the percentage of sales method: looking at your total sales for a period and determining a percentage of those sales that may not be collected. For example, if historically 5% of your sales have ended up as bad debt, you would then set up an allowance for 5% of your current sales.
To calculate the allowance using the percentage of sales method, multiply your total sales by the percentage of bad debt. This will give you the amount you should set aside as an allowance for doubtful accounts.
Aging of accounts receivable method
Another method for setting up an allowance for doubtful accounts is the aging of accounts receivable method. This involves categorizing your outstanding invoices based on how long they have been overdue. The longer an invoice goes unpaid, the less likely it is to be collected.
To use the aging of accounts receivable method, you would first categorize your outstanding invoices based on their age. For example, you may choose to sort your invoices like this: less than 30 days old, between 31-60 days old, between 61-90 days old, and over 90 days old.
Once you have categorized your invoices, you would then assign a percentage likelihood of collection to each group. For example, invoices that are less than 30 days old may have a 90% chance of collection, while invoices over 90 days old may only have a 50% chance of collection.
All of this can help you more accurately estimate how much of your accounts receivable may not be collected and how to prepare for or avoid that.
Impact of bad debt on financial statements
When you have bad debt in your accounts receivable, it impacts your income statement in a few key ways. Firstly, it results in an increase in your bad debt expense, which will directly reduce your net income for the period, impacting profitability.
On your balance sheet, bad debt affects your accounts receivable by reducing the amount of money that is considered collectible. This, in turn, decreases your total assets, as accounts receivable is an asset that represents money owed to your business. Additionally, setting up an allowance for bad debt creates a contra asset account, which is subtracted from your accounts receivable to reflect the portion that is expected to be uncollectible.
Journal entry steps for recording bad debt expense
Initial entry for the sale: When you make a sale and create an accounts receivable (A/R) balance, debit your accounts receivable account and credit your sales revenue account.
Realizing bad debt: Once you determine that a specific customer’s debt is unlikely to be collected, you need to create a journal entry to record the bad debt expense and reduce the accounts receivable. For this entry, you debit the bad debt expense account and credit the allowance for bad debt account.
Writing off the specific bad debt: Finally, if the debt is confirmed as uncollectible, you would make another journal entry to remove the specific customer’s receivable from your records. You would then debit the allowance for bad debt account and credit the accounts receivable account.
Recovering bad debts
When a debt is deemed uncollectible and written off, it’s not the end of the road. There are procedures you can follow to try and recover these bad debts and reconcile your financial records.
Firstly, reach out to the debtor and remind them of their overdue payment. Send polite reminders through emails or letters, and try to establish communication to negotiate a payment plan.
If initial attempts fail, consider employing a debt collection agency to assist in recovering the debt on your behalf.
Accounting for recoveries in financial records
When you are successful in recovering a previously written-off bad debt, you have to accurately account for this recovery in your financial records. To do this, make the following journal entries to adjust your financial statements: debit your accounts receivable account and credit the bad debt expense account.
This will increase your assets and reduce the bad debt expense, thus helping to balance your financial records.
Best practices for managing credit and minimizing bad debts
Implementing clear and well-defined credit policies can go a long way in managing credit efficiently and reducing bad debts.
Establish credit limits for each customer based on their payment history, credit score, and financial stability. Make sure to communicate these credit limits clearly to customers and enforce them consistently. Set clear payment terms, such as due dates and penalties for late payments, to discourage default and encourage timely payments.
Before extending credit to a new customer, you may want to perform a credit check to help you assess their creditworthiness and potential risk of default. Consider using credit reporting agencies or requesting trade references to gather relevant information about the customer’s payment history and financial stability.
Conduct periodic credit reviews to assess changes in your customers’ financial situations, such as bankruptcy filings, late payments, or declining credit scores, and establish a process for monitoring customer payment behaviors and identifying risk factors that could lead to defaults. Keep detailed records of customers’ payment histories, communication regarding overdue payments, and any collection efforts made. By closely monitoring customer creditworthiness, you can identify early warning signs of payment difficulties and take appropriate actions to prevent bad debts.
Conclusion
Don’t let the idea of bad debt scare you: it’s a part of doing business. Your job is to avoid it as much as possible and mitigate it when you can’t. It’s really that simple.
Regularly monitor your accounts receivable so you can quickly identify customers who frequently pay late or not at all. If you see red flags, take immediate steps to lessen losses. Think about implementing stricter credit policies for late-paying customers or prompt payment incentives.
Next, check out our articles on understanding prepaid expenses, 16 best bookkeeping books to read in 2023, and 13 best payroll software, apps & tools in 2023.
FAQ: How to Calculate Bad Debt Expenses for Businesses
Here's some answers to commonly asked questions about How to Calculate Bad Debt Expenses for Businesses.
What does bad debt mean for a business?
Bad debt is the amount of money that a business is unable to recover from its customers or clients who have defaulted on their payments. It results in a loss for the business because the revenue from the sale or service provided is not realized. Bad debt negatively affects a company’s financial health and can have knock-on effects on future business decisions and potential profitability.
How do I estimate bad debt expense?
You can estimate bad debt expense using the allowance method or the direct write-off method. The allowance method requires businesses to estimate and set aside a provision for bad debts based on previous data and industry trends. The direct write-off method directly writes off the outstanding balance as a bad debt expense when a business determines that a customer’s account is uncollectible.
How do I record the recovery of a bad debt?
If you succeed in recovering a previously written-off bad debt, you need to record it in your financial records. First, increase your accounts receivable by debiting this account. Then, you reduce the bad debt expense by crediting this account.
