Reporting bad debt expense on income statement allows companies to accurately and completely report their financial position. Every company, at some point in its existence, will deal with a customer who is not able to pay off their debts. With this, there will be a need for them to record a bad debt expense on income statement. A significant amount of bad debt expense has the ability to change the way potential investors and the executives of a company view the company’s financial health. Therefore, it is critical for bad debt expenses to be recorded accurately and timely. Also, this helps companies to recognize customers who defaulted on payments in order to avoid similar occurrences in the future.
Additionally, recording bad debt expense on income statement comes with tax implications. This is because it brings about an increase in the total expenses and brings about a decrease in net income on the other end. The amount of bad debt expense reported by a company will, therefore, cause a change in the amount of taxes they pay during a given accounting period.
In this article, we will have an in-depth look at bad debt expense on income statement, its formula, how to calculate or recognize it, and its journal entries.
Read also: Accounts Receivable: Debit or Credit?
What is a bad debt expense?
Bad debt refers to the amount of money that must be written off by a creditor as a result of a default on the part of the debtor. If a creditor has a bad debt on his books of accounts, it becomes irrecoverable and it is recorded as a charge-off. In other words, a bad debt expense is simply the amount of an account receivable that cannot be collected or recovered.
Bad debt is a contingency that all businesses that extend credit to customers must account for because there is always a risk that payment will not be collected. These entities may estimate the amount of their accounts receivables that may become uncollectible through the use of either the direct write-off method or the allowance method.
Here, the customer in question has chosen not to pay off this amount either as a result of financial difficulties or because there is a dispute over the underlying product or service sold to the customer. These entities might have exhausted every possible means or avenue to collect on the bad debts before deeming them uncollectible, which includes collection activity and legal action. To some extent, the amount of bad debt expense reflects the credit choices that the seller made when extending credit to customers.
With this, we can see a bad debt as any credit that a lender advances to a debtor that shows no promise of ever being collected, either partially or in full. So, any lender can have bad debt on their books of accounts be it a bank or other financial institution, a supplier, or a vendor. The term can also be used to describe debts that have been taken to pay for goods that do not appreciate. In other words, it is a form of borrowing that does not help a business’s bottom line. This can be used in contrast with good debt which an individual or a company takes out to help generate income or increase their overall net worth.
Payments that are later received for already written-off bad debts are recorded in the book of accounts as bad debt recovery.
Methods of estimating bad debt
- Direct write-off method
- Allowance method
Having established that it is critical for companies and businesses to record bad debts, we look at the right amounts that should be listed on corporate financial statements. This involves the estimation or recognition of irrecoverable debts using any of the methods listed above.
1) Direct write-off method
Under this method, companies directly record bad debt expenses. This happens when it becomes so apparent that a specific customer invoice will not be paid. Here, the company will directly charge the amount of the invoice to the bad debt expense. This is recorded as a debit to the bad debt expense account and a credit to the accounts receivable account. This shows that the expenses are directly linked to a specific invoice as this is not a reduction in sales but rather an increase in expenses.
According to IRS, a company should only write off a debt if there is no longer a chance for the amount owed to be paid. The company must be able to demonstrate that it has taken reasonable steps to collect the debt.
This method is, however, not generally used since it does not follow the matching principle as stated in the generally accepted accounting principle, which states that expenses must be matched to related revenue in the same accounting period in which the transaction takes place. For this reason, the allowance method is used to calculate bad debt expenses. After then that the bad debt expense will be transferred to the income statement under the sales and general administrative expenses section.
Since a company cannot predict the account that will end up in default, it establishes an amount based on an anticipated figure. In this case, historical experience will help in estimating the percentage of money that is expected to be a bad debt.
2) Allowance method/ estimation method
The allowance method is carried out when transactions are recorded and a related amount of bad debt is recorded as well. This is based on the theory that the approximate bad debt amount can be determined on the basis of historical outcomes. This is recorded as a debit to bad debt expense and a credit to allowance for doubtful accounts. The actual elimination of the accounts receivable that are unpaid will later be accomplished by drawing down the amount in the allowance account. This does not imply a reduction in sales.
Under this method, bad debt is recognized as a certain percentage of the sale made or outstanding debtors based on their aging. Such an amount will then be transferred to a separate account, the allowance for doubtful debt accounts. When an actual debt becomes irrecoverable, the account is debited and then the accounts receivable will be reduced by a credit balance.
The allowance for doubtful debt account is a contra-asset account that nets against accounts receivable which mean that the total value of receivables is decreased when both balances are listed on the balance sheet. It is possible for this allowance to accumulate across accounting periods and may be adjusted based on the balance in the account.
The allowance method enables companies to take anticipated losses into consideration on their financial statements in order to limit the overstatement of potential income. To avoid overstatement in the books of accounts, a company estimates the amount of its receivables from the current period of sales that are expected to be delinquent.
The methods of estimating bad debt under the allowance method are as follows:
- Percentage of sale method
- Accounts receivable aging method
- Percentage of receivables
Percentage of sales method
A company can estimate bad debt expense by taking the percentage of net sales, on the basis of the company’s historical experience with bad debt. This method applies a flat percentage to the total amount of sales for the period. Companies make regular changes to the allowance for doubtful debt accounts in order for them to correspond with the current statistical modeling allowances. Here, a certain percentage of sales is recorded as bad debt expenses during each accounting period.
Percentage of sales bad debt expense formula
Bad debt expense = Sale for accounting period x Estimated percentage of bad debts
Note that the sales there is referring to credit sales, So, the formula can be rewritten as:
Bad debt expense = Percentage of sales estimated uncollectible x Actual credit sales
Assuming the company has a historical average annual credit sales of $10,000,000, historical average uncollected credit sales of $500,000, and a historical percentage of credit sales uncollected of 5%. Also, the actual credit sales for this period are $12,000,000.
Here, the 5% estimate can be used to calculate the current period’s bad debt allowance as follows:
Bad debt expense = Percentage of sales estimated uncollectible x Actual credit sales
Bad debt expense = 5/100 x $12,000,000
An important difference between this method and the percentage of receivables method, which will be explained later, is in the adjustment to the allowance for doubtful debt account balance. So when keeping the record of the allowance for doubtful debt on the accounts receivable balance sheet, any existing allowance for doubtful debt account balance from the prior year will be added to the adjustment balance to find the ending balance. When recording bad debt expense on income statement, the adjustment value will be recorded.
Accounts receivable aging method
The accounts receivable aging method groups all outstanding accounts by age and specific percentages are applied to each group. The aggregate result of all groups is the estimate of the uncollectible amount. This method determines the expected losses to delinquent and bad debt by making use of the company’s historical data and data from the industry as a whole. There is a typical increase in the specific percentage as the age of the receivable increases to reflect the increase in default risk and decrease in collectibility.
The accounts receivable aging method is advantageous because it gives the accounts receivables teams a more exact basis for estimating their uncollectible amounts. However, the final probability of collection is still an average and individual outstanding accounts could bring about skewness in the calculations. For instance, one customer may clear 100% of bills within 30 to 60 days while the other customer might have the tendency to default.
Assuming a company has $70,000 of accounts receivable that is less than 30 days outstanding and $30,000 of accounts receivable is more than 30 days outstanding. On the basis of previous experience, 1% of accounts receivable less than 30 days old will not be collectible and 4% of accounts receivable of at least 30 days will not be collectible as well. This will be calculated as:
Bad debt = ($70,000 x 1%) + ($30,000 x 4%)
Bad debt = $700 + $1,200
Bad debt = 1,900
Based on this calculation, it means that the company will report an allowance on bad debt expense of $1,900.
If in the next accounting period, the estimated allowance is 2,500 based on outstanding accounts receivable, Then only #600 ($2,500 – $1,900) will be reported as bad debt expense in the second period.
Percentage of receivables
The percentage of receivables method is similar to the percentage of sales, just that it uses accounts receivable in place of sales. Accounts receivable is an item on the balance sheet as well as a permanent asset account. Sales on the other hand is an income statement item as well as a temporary revenue account, meaning that it resets every year. It is because of this that the steps taken to estimate the allowance for bad debt in this method are different from the percentage of sales method.
Also, another difference is that the result of the calculation using the percentage of receivables method is the company’s ending balance in the allowance for doubtful debt account. This is because any overdue receivables from the previous year have already been accounted for in the receivables balance for the current period.
The result of this calculation is what will be recorded on the accounts receivable on the income statement. However, when recording bad debt expense on income statement, only the adjustment value will be recorded. The adjustment value is the difference between the ending balance of the allowance for doubtful debt account and the starting balance of the same account.
Percentage of receivables bad debt expense formula
The basic formula for estimating bad debt under the percentage of receivables method is as follows:
Bad debt expense = Percentage receivables estimated uncollectible X Receivables balance
Assuming the company’s historical accounts receivable is $15,000,000, the historical cash collected from accounts receivable is $1,200,000, and the historical percentage of uncollected receivables is 8%. Also, the receivables balance is $18,000,000
The 8% estimate can be used to calculate the current period’s bad debt allowance as follows:
Bad debt expense = Percentage receivables estimated uncollectible X Receivables balance
Bad debt expense allowance = 8/100 x $18,000,000
Bad debt expense allowance = $1,440,000.
Percentage of bad debt expense formula
Because a company sets it up ahead of time, its allowance for bad debts will always be an estimate, and estimating bad debt expenses usually involves the application of the percentage of bad debt formula which is as follows:
Percentage of bad debt = Total bad debts / Total credit sales
If for example, a business has existed for a year and it made credit sales of $300,000 in the first year while $20,000 ends up uncollectible. To set up an allowance for bad debt, one has to, first of all, figure out the percentage of bad debts which will be as follows:
Percentage of bad debt = $20,000 / $300,000
Percentage of bad debt = 6.67%
The company can then use this percentage to estimate future uncollectible accounts and then create an allowance for doubtful debts equal to say, 6.67% of this year’s projected credit sales. If in January, the company has $50,000 credit sales, it might record an adjusting entry for its allowance for bad debts account for $3,335 (6.67% x $50,000).
This method is, however, not always reliable for predicting future bad debts especially if one has not been in business for a very long time or if one big bad debt is bringing about a distortion in the percentage of bad debt.
Presentation of bad debt expense on income statement
The bad debt expense is recorded in a line item on the income statement within the operating expenses section, which is located on the lower half of the income statement. Not that bad debt expense on income statement is not considered a direct cost of sales.
One should also note that the bad debt reserve and bad debt expense on income statement serve a different purpose from the bad debt allowance on a company’s corporate balance sheet. The income statement provides a report on a company’s income and expenses for a given accounting period, which is different from the cash flow statement. It includes credit purchases and credit sales. The income statement gives a better idea of how profitable a company was during a given accounting period than if one just looks at cash.
The balance sheet reports a company’s assets and liabilities at the end of a given accounting period. The total value of the assets equals the total liabilities plus the owners’ equity. Studying the balance sheet shows the worth of the business and whether its debt load is too high
Journal entries for bad debt expenses
It is an important step for companies to record bad debt expenses as this will help in keeping their books balanced. Also, a company will have a realistic insight into its company accounts, allowing for better financial decisions. However, there is a need to record bad debt expenses only if the company is using an accrual basis of accounting, which most businesses use as recommended by GAAP standards.
Businesses that make use of cash accounting principles never keep a record of the amount as incoming revenue, to begin with, so there would not be a need to undo expected revenue when an outstanding payment or accounts receivable becomes bad debt. This means that a company has nothing to undo or balance as bad debt if it uses cash-based accounting.
Having said that, there are two situations in recording a bad debt expense in a journal entry, when directly writing off accounts receivable deemed uncollectible and when establishing a reserve or allowance for bad debts. Recording bad debt expenses involves a debit and credit entry. While a debit entry is made to a bad debt expense account, an offsetting credit entry is made to a contra asset account which is the allowance for doubtful debt account. As earlier stated, the allowance for doubtful debt account nets against the total accounts receivable presented on the balance sheet to reflect only the estimated collectible amount. This allowance accumulates across accounting periods and may be adjusted based on the balance in the accounts.
Journal entry using the direct write-off method
Assuming Company ABC Inc. wants to directly write off a $900 account receivable that is thought to no longer be collectible. After calling the customer one last time and getting their answering machine, they would make a journal entry as follows:
|Bad debt expense||900|
Journal entry using the allowance method
Assuming after calculating a company’s percentage of bad debts, the company decided to establish an allowance for bad debts account of $2,000 in its books at the end of the month. It will make the following journal entries:
|Bad debt expense||2,000|
|Allowance for bad debts||2,000|
As earlier stated, a company’s allowance for bad debts is a contra-asset account, meaning that it will appear on the balance sheet alongside other asset accounts.
Assuming that a few weeks later, one of the company’s customers says it will not be able to pay off a $200 amount owing, this account receivable will be written off, and the journal entry will be:
|Allowance for bad debts||200|
The act of establishing an allowance for bad debts is a way to make plans ahead for uncollectible accounts by estimating the amount of bad debts that may be encountered. This can budget some of the operational expenses for a company, as an allowance account to make up for its losses. Setting this amount aside enables a company and its accounting department to get a better insight into what is actually going on with the company’s finances. This includes where assets stand and the amount of accounts receivables are actually planned to collect.
Irrecoverable debts and allowance for receivables
Irrecoverable debts should not be confused with allowance for receivables. These terms are discussed below:
Writing off an irrecoverable debt implies taking a customer’s balance in the receivables ledger and transferring it to the income statement as an expense. This is because the balance has been proven irrecoverable. Irrecoverable debts are the bad debts we have been discussing here, and adjustment into two figures is needed. This amount goes to the income statement as an expense and it is deducted from the receivables figure in the statement of financial position/balance sheet.
Allowance for receivables
Companies set up this allowance in order to include a realistic value for receivables in the balance sheet, without actually writing off the debt. The balance is left in the receivables ledger in order for the collection procedure to continue. The receivables on the balance sheet are, however, valued as if the amount is not to be recovered. It will be shown on the trial balance as follows:
|Dr $||Cr $|
|Allowance for receivables||3,800|
Note that these are tentative figures. The entries mean that the business already has an allowance brought forward from the previous year’s statement of financial position. If nothing more is done, then under current assets, this should appear.
|Less: Allowance for receivables||3,800|
There may be a requirement for the question to be adjusted. Assuming that the allowance is to be increased to $5,000, given that there is already $3,800, $1,200 will be charged as a bad debt expense on income statement as shown below:
|Increase in allowance for receivables||1,200|
It is important to note that only an increase or decrease in the allowance goes into the income statement.
Read also: Is Accounts Receivable an Asset or Revenue?
Recovery of bad debts
There are times in which a debt written off is recovered or paid in the next year, that is a debit to cash and a credit to irrecoverable debts recovered. The credit on the balance is then transferred to the income statement, added to gross profit, and included as a negative in the list of expenses. This may be clearer than crediting the recovery to the bad debts expense account because that would make the expense from the year’s bad debt unclear. However, if the amounts are small compared to the other expenses on the income statement, it would not be correct.