What Are Bad Debt Expenses: Definition And How To Calculate It?

Suppose your business offers its customers payment terms such as Net 30 and Net 15, you will ultimately bump into a customer who will make excuses to pay you off or possibly he could not pay you in real at all. When such situations keep piling up, you call it bad debt expenses. 

The owner has to give up the idea of collecting a debt (lies under account receivable) and has to erase them from your business by mentioning them as an expense, and it is called bad debt expenses.

This article will discuss more lousy debt expenses, where and how to find them on your financial statements, and record them the right way. 

First, let us understand what bad debt expenses are?

What Is A Bad Debt Expense?

A financial transaction recorded as bad debt, but now the business has given up on receiving it; is a bad debt expense. 

You can use bad debt expenses when applying accrual accounting principles. However, bad debts are still bad if you prefer cash accounting principles; however, since you never registered it as an income, there is no revenue to “undo” with a bad debt expense transaction. 

Bad debt expense makes it transparent for the business owner to recognize what is happening within his business and why your net income is not rising from its current number?

You can also use bad debt expenses as a tool to reduce your tax bills and manage to save your earned profits!

Importance of Bad Debt Expense

A business will surely meet a set of customers who will not pay for the services they availed. It might be because they are unable to pay, or unwilling to pay due to disagreements. So, having bad debts in business is inevitable. Bad debt expenses have significance due to multiple reasons:

• Due to well-defined accounting principles, the bookkeepers can record these bad debt expenses accurately. It allows the company to present its verifiable financial condition. The portion of bad debt a company determines its financial health to investors, executives, and other stakeholders in the business.
• Timely recording of bad debt expense in books develops an understanding for the company. The executives will determine how to recognize different types of customers and how to avoid defaulters in the future.
• Not to mention how Bad debt expenses lead to tax implications. Timely reporting of this item increases total expenses, decreases net income, and thus, reduces taxable income during a fiscal period.

How Exactly Can You Find Bad Debt Expenses?

You can find bad debt expenses in your general ledger account like other expense accounts. Bad debt expenses are the operating costs, and you can discover them in the income statement within selling, general and administrative costs of your business.

Is There A Way To Write Off Your Accounts Receivables Directly?

You can quickly write your accounts receivables off individually once confirmed that the customer would not pay. 

Transact the bad debt expense into your general ledger equal to the account receivable. 

But there must be asking, “how do I know if this is the right time to write off a bad debt as irrecoverable?” 

You must write off your debts only when it is confirmed that the amount owed is not receivable anymore, and you must display that you have taken proper steps to recover the amount. 

Suppose you fail to connect to the customer via phone or set up a repayment plan; you must write off the debts now.  

What Is The Allowance Method?

You can foresee bad debts prior to their occurrence within the allowance method. You set up the allowance account with an estimated figure as its base. It is the value your business expects to lose each year. 

The contra asset account diminishes the loan receivable account when both are induced into the same balance sheet.

Along with the sales transaction, the accountant also records the bad debt expense.

The accountant transacts it as the debit to the bad debt expense account and credits the allowance for doubtful accounts; the unpaid funds are nulled at the end of the year and draw them down to the allowance account. 

What are the different ways of estimating bad debt, as per the allowance method?

Any enterprise can compute its bad debts with these two methods, i.e., percentage of accounts receivable method and percentage of sales method. Let us dive deeper into both topics:

#Percentage of the accounts receivable method

In this method, the accountant computes bad debts as the percentage of the accounts receivables balance and figures the estimated value out. 

For instance: by the end of your accounting phase, you have $40,000 in the account receivable. And you have recorded that 4% of the receivable accounts are not collectible. 

You have to keep a certain amount (allowance) aside for bad debts to hold a credit balance of $1600 (4% of $40,000) 

#Percentage of sales method

The percentage sales method estimates the bad debts emerging from the credit sales that are not collectible anymore. 

The determined percentage is then multiplied by the sum of credit sales to identify the bad debt expense. 

For instance, the net credit sales in an accounting phase are $40,000 under the percentage of sales method, 4% of the credit sales are identified as irrecoverable, and the business computes $1600 as the bad debt expense.  

How to record a bad debt expense?

Knowing how to calculate Bad debt expenses is simple. As earlier mentioned, one can record bad debt expense in their books by two methods: direct bad debts written off and allowance method.

In the allowance method of determining bad debt expense, two general ledger accounts are made; bad debts (the expense account), an allowance for a doubtful account (the contra-asset account that offsets the debtors/account receivable balance).

The entries:

Date Accounts Reference Debit Credit

31-July-21 Bad Debt Expense $180

Allowance for Doubtful Accounts $180

02-Aug-21 Allowance for Doubtful

Accounts $180

Accounts Receivables $180

In the direct bad debts written off method, the complete balance of debtors/account receivables are mentioned as a current asset in the balance sheet.

The entry:

Date Accounts Reference Debit Credit

31-July-21 Bad Debt Expense $180

Accounts Receivables $180

Examples of Bad Debts Expense

For instance, Wizardinfo is a data analytics company. It has provided services worth $1,000,000 to its ten clients. In the income statement, this is revenue. In the balance sheet, this amount is shown as accounts receivable. (Net 60)

Wizardinfo comes to know that one of their clients, Megazone, is running into losses. It has also stopped paying for its expenses, and so they won’t pay their pending bill of $100,000 with Wizardinfo.

Now, Wizardinfo isn’t sure of receiving its pending payment, so it writes $100,000 as bad debt. It will adjust its balance sheet to reflect $1,000,000 as accounts receivable and $100,000 as Bad debt reserves. Therefore, the net accounts receivable will be $900,000.

If Wizardinfo cannot collect the pending amount even in the case of Megazone’s liquidation, it will mention $100,000 in its income statement as Bad debt expense. In other words, it will reduce the Bad debt reserves by a similar amount, which will decrease the net income.

How to calculate bad debt percentage?

You will always count your allowance for bad debts because they are esteemed before the actual bad debts happened. You can compute your bad debts with this formula, where your previous bad debts are divided by your last credit sales. 

Percentage of bad debt = Total bad debts / Total credit sales

Let’s assume you have been running a business for a year, and out of $400,000 of the credit sales, you ended up receiving $40,000 as irrecoverable. Now you want to establish an allowance for the bad debts. How would you decide the amount?

Firstly you have to find the percentage of your bad debts:

Percentage of bad debts = 40,000/400,000

The percentage of bad debt is = 10% 

If you find 10% suitable for the allowance amount, keep the same for the next year’s irrecoverable accounts.

If you made $60,000 credit sales in January,  mention $6000 into your bad debt account allowance. 

Conclusion:

It would be best if you recorded your bad debts every time your business records its financial statements. Not doing so may overstate your company’s assets and net income.

Recognizing and computing bad debt expenses allows the business to spot the customers that default on payments more than others. You can utilize this information to spot out the creditworthy customers and benefit them with different discount offers.