Understanding Bad Debt

A bad debt is an amount which has been written off by the business as a loss, and categorized as an expense, because the debt owed to the business cannot be collected. This generally occurs when the debtor declares bankruptcy or when the cost of pursuing further action in an attempt of collecting the debt becomes more costly than the debt itself.

How do you know how much bad debt to anticipate?

Bad debt is an unfortunate but unavoidable part of doing business. Two primary methods exist for estimating the dollar amount of accounts receivables expected to become “uncollectible”.

1. Accounts Receivable Aging Method

   This method can use statistical modeling and historical data from the business, as well as from the industry as a whole. The aging method groups all outstanding accounts receivable by age and specific percentages are applied to each group. The specific percentage will typically increase as the age of the receivable increases, to reflect increasing default risk and decreasing collectability. The aggregate of all groups' results is the estimated uncollectible amount.
   
   Let’s say a company has $100,000 of accounts receivable less than 30 days outstanding, and $30,000 of accounts receivable more than 30 days outstanding. Based on historical data, 1% of accounts receivable less than 30 days old will not be collectible and 4% of accounts receivable at least 30 days old will be uncollectible.
   
   Therefore, the company will report an allowance and bad debt expense of $2,200 (($100,000 * 1%) + ($30,000 * 4%)).
   
   If the next accounting period results in an estimated allowance of $2,500 based on outstanding accounts receivable, only $300 ($2,500 - $2,200) will be the bad debt expense in the second period.

2. Percentage of Sales Method

   This method estimates a flat percentage of net sales for the period based on previous experience.
   
   For example, using historical data, a company may expect that 2% of net sales are not collectible. If the total net sales for the period is $100,000, the company establishes an allowance for doubtful accounts for $2,500 while simultaneously reporting $2.500 in bad debt expense.
   
   If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $1,600 is recorded in the second period in bad debt expense. The aggregate balance in the allowance for doubtful accounts after these two periods is $4,100.

Accounting for Bad Debt

The two methods of recording bad debt are 1) direct write-off method and 2) allowance method.

1. Bad Debt Direct Write-Off Method

   This method involves a direct write-off to the receivables account. In this approach, bad debt expense serves as a direct loss from uncollectibles, which goes against revenues and lowers your net income.

2. Bad Debt Allowance Method

   The allowance method is preferred compared to the direct write-off method, especially for larger amounts. This method involves a contra asset account that goes against accounts receivables. A contra asset account is basically an account with an opposite balance to accounts receivables and is recorded on the balance sheet.

Why do you need to understand Bad Debt?

Bad debt expense helps companies identify which customers default on payments, and if any do so with regularity. This information can help them make decisions on creating loyalty programs, how they manage collections, what types of payment incentives they might offer, and if they need to reassess their processes for determining creditworthiness.

In addition, financial statements are usually prepared every quarter - or at least annually - and are viewed by both investors and potential investors. Investors are relying on truthful financial statements to make sound investment decisions. If bad debt is not part of the financial statements, there could be significant misrepresentation of the company’s actual revenue.