Is Bad Debt Expense Part of Operating Expenses or Cost of Goods Sold?

As mentioned above, bad debts involve two sides when accounting for these amounts. The first requires creating an expense that reduces profits or increases losses. While one or two bad debt expenses of small amounts may not make much of an impact, large debts or several unpaid accounts may lead to significant loss and even increase a company’s risk of bankruptcy. Another company that was growing rapidly, Johnstone Supply, grew concerned about its exposure to potential bad debt expense as its customer base expanded. In the past, the company knew all of its customers either personally or by reputation.

Percentage of Sales

Simultaneously, a contra-asset account called “allowance for doubtful accounts” (or “allowance for credit losses” or “allowance for bad debts”) is created to record the estimated uncollectible amount. This account is used to offset the accounts receivable account to present a more accurate picture of a company’s collectible assets. This process involves removing the account from the accounts receivable balance and recording it as a bad debt expense. Writing off accrued expenses uncollectible accounts affects both the income statement, where it is recorded as an expense, and the balance sheet, where it reduces the total receivables. An allowance for doubtful accounts is an accounting provision made to cover potential losses from uncollectible accounts receivable.

What Is Bad Debt Expense? How To Calculate and Record Bad Debt (With Examples)

The allowance method ensures bad debt expenses are recognized in the same period as the related sales, providing a more accurate reflection of a company’s financial health. This method is favored over the direct write-off method, which records bad debt only when specific accounts are deemed uncollectible and can lead to discrepancies in financial reporting. The aging of receivables method involves a more detailed analysis of accounts receivable based on the length of time they have been outstanding. Receivables are categorized into age groups, such as current, 1-30 days past due, days past due, and so on. Each category is assigned a different percentage likelihood of becoming uncollectible, reflecting the increased risk of non-payment over time. For example, current receivables might have a 1% estimated default rate, while those over 60 days past due might be assigned a rate of 20%.

This not only aids in precise financial reporting but also supports strategic decision-making by highlighting areas of risk and opportunity within the receivables portfolio. Incorporating industry benchmarks and economic indicators further refines these estimates. Industry benchmarks allow businesses to evaluate their position relative to peers, particularly in industries prone to high default rates, such as retail or hospitality. In contrast, the cash accounting method does not require the estimation of bad debts since it records transactions only when cash is what is debit in accounting received or paid. On the other hand, companies can impose late payment fees to discourage late payments and manage cash flow.

Average Collection Period: Calculator, Examples, Ways to Improve

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• Businesses using the cash basis of accounting generally cannot claim bad debt deductions, as income from these receivables was never recognized.
• To avoid an account overstatement, a company will estimate how much of its receivables from current period sales that it expects will be delinquent.
• The allowance method is necessary because it enables companies to anticipate losses from bad debt and reflect those risks on their financial statements.
• Operating expenses and bad debt expenses are distinct categories within a company’s financials, each reflecting different aspects of business operations.
• The bad debt expense reverses recorded revenue entries in subsequent accounting periods when receivables become uncollectible.

The term bad debt could also be in reference to financial obligations such as loans that are deemed uncollectible. More specifically, the product or service was delivered to the customer, who already reaped the benefit (and thus, the revenue is considered to be “earned” under accrual accounting standards). In this example, the net accounts receivable of $45,000 is shown after deducting the $5,000 allowance for doubtful accounts from the gross receivables of $50,000. The entries to post bad debt using the direct write-off method result in a debit to ‘Bad Debt Expense’ 257 budget categories to help you think of every expense and a credit to ‘Accounts Receivable’. There is no allowance, and only one entry needs to be posted for the entry receivable to be written off.

This process may involve analyzing credit reports, financial statements, and conducting background checks to assess creditworthiness. Clear credit terms and conditions also help set expectations and reduce the likelihood of default. The allowance for doubtful accounts is adjusted periodically to reflect the current estimation of uncollectible receivables. When specific debts are identified as uncollectible, they are written off against the allowance account, not affecting the income statement further since the expense has already been recognized. This method of reporting ensures that the impact of bad debts on a company’s profitability is recognized in a timely manner and that receivables are not overstated on the balance sheet. Bad debt expense is reported within the selling, general, and administrative expense section of the income statement.

Percentage of Receivables Method

The percentage of sales method is a straightforward approach that estimates bad debt expense based on a fixed percentage of total sales for the period. This percentage is typically derived from historical data, such as past bad debt ratios. Bad debt expense affects accounts receivable by creating an allowance that represents the estimated uncollectible portion of the accounts receivable. This allowance is accounted for when reporting the net Accounts Receivable on the balance sheet, thus reducing the reported value of accounts receivable to accurately reflect collectible amounts. Bad debt expense can have significant effects on a company’s financial statements.

• Vivek Shankar specializes in content for fintech and financial services companies.
• Bad debt expense can have significant effects on a company’s financial statements.
• These resources offer both theoretical knowledge and practical insights, ensuring that your accounting practices are robust and compliant.
• Like any other expense account, you can find your bad debt expenses in your general ledger.
• Once the estimated bad debt figure materializes, the actual bad debt is written off on the lender’s balance sheet.
• The final collection probability is however still an average and individual outstanding accounts could skew calculations.

Allowance Method

For example, a company could dictate tighter credit terms based on each customer’s unique circumstances. In some cases, a company might avoid extending credit at all by requiring a buyer to procure a letter of credit to guarantee payment or require prepayment before shipment. In summary, properly reporting bad debt expenses requires understanding and adhering to the relevant accounting principles and regulatory requirements.

Bench simplifies your small business accounting by combining intuitive software that automates the busywork with real, professional human support. Bad debt protection can help limit some losses when customers are unable to pay their bills. Vivek Shankar specializes in content for fintech and financial services companies. He has a Bachelor’s degree in Mechanical Engineering from Ohio State University and previously worked in the financial services sector for JP Morgan Chase, Royal Bank of Scotland, and Freddie Mac.

With the direct write-off method, the expense is recorded when a specific account is deemed uncollectible, debiting bad debt expense and crediting accounts receivable. It refers to the outstanding accounts receivable that a company anticipates will go unpaid, rendering them virtually worthless. This usually occurs when customers are unable or unwilling to pay for the goods or services provided on credit by the company. As a result, businesses need to estimate, record and adjust for bad debt expense to maintain accurate financial statements and ensure smooth financial operations. Regularly reviewing and adjusting bad debt estimates and the allowance for doubtful accounts ensures that the company’s financial statements accurately reflect the risk of uncollectible receivables.

This type of expense is categorized as an extraordinary or non-recurring expense and is typically excluded from operating expenses. By referring to these guidelines, sources, and further readings, you can gain a comprehensive understanding of how to calculate and manage bad debt expense under GAAP. These resources offer both theoretical knowledge and practical insights, ensuring that your accounting practices are robust and compliant. Over time, companies need to adjust the allowance for doubtful accounts to reflect new information about the collectibility of receivables. Additionally, when specific accounts are identified as uncollectible, they must be written off against the allowance for doubtful accounts.