A bad debt expense is a line item in your accounts receivable that cannot be collected, usually due to a customer or client being unable to meet their financial obligations. There’s always a risk of not receiving the money you expect when you extend credit to customers or get paid via invoice.
“When a business makes sales on credit, even customers with the best credit record and financial standing can go bankrupt and fail to pay the bills they owe,” Keela Helstrom writes in the Houston Chronicle.
Unfortunately, this happens to many small businesses. When it does, there are some accounting principles to follow in order to reflect bad debt expenses in your financial reports.
“When a customer defaults on its bills or is in danger of doing so, the company extending credit to that customer faces a bad debt expense,” financial firm Euler Hermes explains. “Bad debt expense reflects the amount of accounts receivable that a company is unable to collect now and may not be able to collect in the future. Because this bad debt expense must be charged against the company’s accounts receivable, bad debt expense reduces the amount of accounts receivable on the company’s income statement.”
As a business, you’ll have to decide when an accounts receivable has gone sour—if you’ve made several attempts to collect over the weeks or months to no avail, you probably have a bad debt expense on your hands. Many companies decide that a debt over 90 days old should become a bad debt expense.
It’s important to record this situation accurately because it means your actual cash flow will be lower than your reported revenue.
Calculating Bad Debt Expenses
Businesses follow 2 methods of calculating bad debt expenses: the direct write-off method and the allowance method. In the former method, you record the specific bad debt expenses; in the latter, you notate bad debt expenses as an ongoing cost of doing business.
Direct Write-Off Method
With the direct write-off method for calculating your bad debt expenses, you report the bad debt on your profit and loss statement when you determine that the debt is uncollectible. In your ledger, you’ll make an entry that debits bad debt expense and credits accounts receivable.
While it might seem more accurate, the direct write-off method is less preferred by accountants because of timing. You might not realize a debt is uncollectible until months after you record a sale. Your company’s reports could become less accurate as a result: they could show a higher amount of revenue than what you’d actually collect if you created the reports before writing off the bad debt expense.
With the allowance method for calculating bad debt expenses, you anticipate that some of your customers won’t pay before you even make a sale and incorporate that into your bookkeeping. Estimate how much of your sales will result in bad debt expenses and create a contra-asset, or negative asset, on your ledger as allowance for doubtful accounts.
Estimating your projected bad debt expenses relies on a number of factors: your industry, your customer base, your location, and the wider economy. It’s best to use your own business’s data from previous years to estimate your allowance for doubtful accounts.
Following the allowance method, you’ll adjust your ledger entries during every accounting period based on these anticipated bad debt expenses by debiting the amount from your bad debts expense and crediting it to your contra-asset allowance for doubtful accounts.
When you decide that it’s no longer viable to collect on a payment, debit the allowance for doubtful accounts and credit accounts receivable.
Which Method Should You Use?
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.
You might prefer the direct write-off method because you write off revenue as an expense when you decide you won’t get paid—but because of its timing, this approach violates generally accepted accounting principles (GAAP).
How Can You Protect Yourself From a Bad Debt Expense?
The most surefire way to protect yourself from bad debt expenses is to require cash up front for any work or sale. Even setting stricter terms for repayment or requiring a guarantor can reduce your chances of loss.
Using the allowance method for calculating bad debt expenses is a form of protection in some sense—even though it can’t force delinquent customers to pay up, it at least prepares you mentally and financially for the possibility that some money is uncollectible.
There are also firms that offer bad debt protection and trade credit insurance to help protect businesses—however, be sure to review their terms carefully when shopping for policies because there are many situations where your business might not be covered.