Bad Debt

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Main Findings

• Bad debt expense is an expense recorded in financial statements when the amount receivable from debtors is not recoverable due to the inability of debtors to meet their financial obligations.
• Bad debt expense can be calculated using two methods: the direct method and the allowance method.

Bad debt is an amount of money that is owed by a debtor to a creditor but is unlikely to be paid or recovered.

Bad debt can occur for various reasons, such as the debtor's financial difficulty, bankruptcy, fraud, or negligence. Bad debt is a loss for the creditor and reduces their income and cash flow.

Why is bad debt important?

Bad debt is important because it affects the financial performance and position of the creditor. Bad debt reduces the revenue and profit of the creditor, as well as their assets and equity. Bad debt also increases the risk and uncertainty of the creditor's future cash inflows and credit quality. Therefore, creditors need to manage their bad debt effectively and minimize its impact on their business.

Formula for Bad Debt

There is no single formula for bad debt, as different methods can be used to estimate and account for it. However, one common way to measure bad debt is by using the bad debt ratio, which is calculated as:

Bad debt ratio = Bad debt / Total credit sales

The bad debt ratio shows the percentage of credit sales that are expected to become uncollectible. A higher ratio indicates a higher risk of bad debt and a lower credit quality.

How to Calculate Bad Debt

To calculate bad debt, creditors need to use an estimation method that complies with the accounting standards and principles. There are two main methods that are used to estimate bad debt: the direct write-off method and the allowance method.

The direct write-off method records bad debt as an expense when it is identified as uncollectible. This method is simple and accurate, but it violates the matching principle, which requires expenses to be matched with revenues in the same period.

The allowance method records bad debt as an expense based on an expected amount of uncollectible accounts in the same period as the credit sales. This method follows the matching principle, but it involves estimation and uncertainty.

To use the allowance method, creditors need to estimate the amount of bad debt using either the percentage of sales method or the accounts receivable aging method.

The percentage of sales method estimates bad debt as a percentage of total credit sales, based on historical experience or industry average. For example, if a creditor expects 2% of its credit sales to become uncollectible, and its credit sales for the period are $100,000, then its bad debt expense is $2,000 (2% x $100,000).

The accounts receivable aging method estimates bad debt based on the age and collectability of each account receivable. For example, if a creditor has $50,000 of accounts receivable, and assigns different loss rates to different age categories, such as 1% for current accounts, 5% for 30 days past due accounts, 10% for 60 days past due accounts, and 50% for 90 days or more past due accounts, then its bad debt expense is $3,250 (1% x $20,000 + 5% x $10,000 + 10% x $5,000 + 50% x $15,000).

Examples

To illustrate how to calculate bad debt expense using the allowance method, let's look at an example. Suppose ABC Inc. sells goods worth $100,000 on credit to XYZ Ltd. in January 2024. ABC Inc. estimates that 2% of its credit sales will be uncollectible, based on past experience and future expectations.

Therefore, ABC Inc. records a bad debt expense of $2,000 ($100,000 x 2%) in January 2024, along with a corresponding increase in the allowance for doubtful accounts.

The journal entry for this transaction is:

Debit Bad Debt Expense: $2,000

Credit Allowance for Doubtful Accounts: $2,000

This entry reduces the net income of ABC Inc. by $2,000 and also reduces the net accounts receivable by the same amount. The balance sheet of ABC Inc. as of January 31, 2024, would show:

Accounts Receivable: $100,000

Less: Allowance for Doubtful Accounts: $2,000

Net Accounts Receivable: $98,000

In February 2024, XYZ Ltd. informs ABC Inc. that it has filed for bankruptcy and cannot pay its debt of $100,000. ABC Inc. decides to write off the entire amount as uncollectible. To do so, it makes the following journal entry:

Debit Allowance for Doubtful Accounts: $100,000

Credit Accounts Receivable: $100,000

This entry reduces the accounts receivable and the allowance for doubtful accounts by $100,000 each but does not affect the net income or the net accounts receivable of ABC Inc., since the bad debt expense was already recognized in January 2024.

The balance sheet of ABC Inc. as of February 28, 2024, would show:

Accounts Receivable: $0

Less: Allowance for Doubtful Accounts: $0

Net Accounts Receivable: $0

Limitations

The main limitation of using the allowance method to calculate bad debt expense is that it relies on estimates and assumptions that may not be accurate or reliable. The percentage of bad debt formula is based on historical data and future projections that may not reflect the actual conditions or circumstances of the current accounting period.

For example, if the credit policy or the economic environment changes significantly, the percentage of bad debt may need to be adjusted accordingly.

Another limitation of using the allowance method is that it does not comply with the matching principle of accounting, which states that expenses should be matched with the revenues they help generate in the same period.

By estimating bad debt expense at the end of each accounting period, rather than when a specific account becomes uncollectible, the allowance method may not match the bad debt expense with the corresponding revenue in the same period.

Conclusion

Bad debt expense is an expense recorded in financial statements when the amount receivable from debtors is not recoverable due to the inability of debtors to meet their financial obligations. Bad debt expense can be calculated using two methods: the direct method and the allowance method.

The direct method records bad debt expense when a specific account becomes uncollectible, while the allowance method estimates bad debt expense based on a percentage of credit sales or outstanding debtors at the end of each accounting period.

The direct method is simpler and more accurate than the allowance method, but it does not uphold the matching principle of accounting and may overstate or understate net income and net accounts receivable in different periods.

The allowance method is more complex and less accurate than the direct method, but it upholds the matching principle of accounting and smooths out net income and net accounts receivable over time.

References

• Bad Debt Expense Formula | How to Calculate? (Examples) - WallStreetMojo: https://www.wallstreetmojo.com/bad-debt-expense-formula/
• Bad Debt Expense: Definition and How to Calculate It - Bench Accounting: https://www.bench.co/blog/accounting/bad-debt-expense/
• Bad Debt Expense Calculator - Calculator Academy: https://calculator.academy/bad-debt-expense-calculator/
• What Is the Bad Debt Expense Formula? | Xendoo: https://xendoo.com/blog/bad-debt-expense-formula/

FAQ

Bad debt is money owed that is unlikely to be paid back, while doubtful debt is money owed that might become bad debt. In other words, doubtful debt is still considered recoverable, but there’s uncertainty.

Bad debt is recorded as an expense on the income statement, reducing net income. It also reduces the accounts receivable on the balance sheet.

A provision for bad debts is an estimated amount that a company sets aside in anticipation of potential non-payment or default from its customers.

The provision for bad debts is typically calculated based on the company’s historical bad debt experience, current economic trends, and the aging of the accounts receivable.

Bad debt can negatively impact cash flow as it represents revenue that was reported but will not be collected.

Yes, bad debt can be written off for tax purposes. However, the specific rules and requirements for writing off bad debt may vary by jurisdiction.