How to Calculate Bad Debt Expense

Accountants record bad debt as an expense under Sales, General, and Administrative expenses (SG&A) on the income statement. They argue that it is a mistake to classify this expense as a non-operating one because it is recorded on the cash flow statement and affects its cash position. Another argument favoring classifying bad debt as a non-operating expense is that bad debt comes from lending money to their customers, and they are unlikely to get it back. Bad debt expense is a natural part of any business that extends credit to its customers. Because a small portion of customers will likely end up not being able to pay their bills, a portion of sales or accounts receivable must be ear-marked as bad debt. This small balance is most often estimated and accrued using an allowance account that reduces accounts receivable, though a direct write-off method (which is not allowed under GAAP) may also be used.

Likewise, the calculation of bad debt expense this way gives a better result of matching expenses with sales revenue. For example, the expected losses from bad debt are normally higher in the recession period than those during periods of good economic growth. What is the exact amount that should be set as a reserve to cover bad debt expenses? This is one of the questions many people ask themselves how to calculate bad debt charges.

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This amount must then be recorded as a reduction against net income because, even though revenue had been booked, it never materialized into cash. The result from your calculation in the percentage of receivables method is your company’s ending AFDA balance for the end of the period. This is because any overdue receivables from the year prior are already accounted for in the receivables balance for the current period. The matching principle states that companies must record all expenses and the revenue connected to them in the same period. Per the allowance method, companies create an allowance for doubtful accounts (AFDA) entry at the end of the fiscal year.

The writing off is done once the company is certain that the company will not pay. It is easy for businesses to keep up with the number of bad debts in such a case. If you have not been in business for many years, this method might be highly unreliable.

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There’s always a risk of not receiving the money you expect when you extend credit to customers or get paid via invoice. The bad debts are the losses that the business suffers because it did not receive immediate payment for the sold goods and provided services. bad debt expense calculator Establishing an allowance for bad debts is a way to plan ahead for uncollectible accounts. By estimating the amount of bad debt you may encounter, you can budget some of your operational expenses, as an allowance account, to make up for some of your losses.

If your company’s income appears higher than it actually is, you might get the wrong impression. For instance, a company might believe that it is making huge sales and, therefore, stop being aggressive with its marketing campaigns. This means that its products will not reach many consumers as expected, and in the real sense, the company might end up making losses. At CNBC Select, our mission is to provide our readers with high-quality service journalism and comprehensive consumer advice so they can make informed decisions with their money. Every article is based on rigorous reporting by our team of expert writers and editors with extensive knowledge of personal loan products.

Direct Write-Off Method

The allowance method is preferred by most accountants—this way, your business is not surprised by a bad debt expense. Because of how you debit your contra-assets and credit accounts receivable, the record of your bad debt expenses is closer to the real transaction time. With the allowance method, a bad debt expense is less likely to throw off your profit and loss statements and balance sheets, especially if you wait a long time to decide a payment is uncollectible. As explained earlier, the allowance method involves a prediction of the doubtful debt to determine a reserve amount.

• Instead, it is an asset deducted from its accounts payable (liabilities) account.
• The rule is that an expense must be recognized at the time a transaction occurs rather than when payment is made.
• For instance, a company might believe that it is making huge sales and, therefore, stop being aggressive with its marketing campaigns.
• If you are not prepared to pay this fee, your business is likely to suffer huge losses and may eventually go bankrupt.
• The bad debt expense reverses recorded revenue entries in subsequent accounting periods when receivables become uncollectible.

However, this is not sustainable, and over time, bad debt can have severe implications for a business’s financial health. If, as the statistics suggest, most enterprises are already chasing £68,413 in unpaid invoices, writing off an additional £16,641 every year is more than enough to push many companies into financial difficulty. Like all accounting principles, bad debt expense allows companies to accurately and completely report their financial position. The reliability of the estimated bad debt – under either approach – is contingent on management’s understanding of their company’s historical data and customers.