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Bad Debt

Guide to Understanding Bad Debt

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Bad Debt

Bad Debt: Definition in Accounting (“Bad A/R”)

In accounting, bad debt emerges from customers that purchased a product or service using credit as the form of payment, rather than cash, yet are unable to fulfill their obligations to eventually pay in cash.

The company had extended short-term credit to the customer as part of the transaction under the assumption that the owed amount would eventually be received in cash.

The customer, however, can be incapable of paying the company back – e.g. if they filed for bankruptcy or face unanticipated financial difficulties – resulting in the recognition of bad debt for bookkeeping purposes.

Once the company recognizes the outstanding payment still owed from the customer, in all likelihood, will not be received, the recognition of bad debt becomes necessary to accurately reflect its operating performance on its financial statements for the sake of transparency.

The bad debt account attempts to capture the estimated amount that the creditor (i.e. the seller) must write off from the “default” of the debtor (i.e. the buyer) in the current period. The reason the expense is an “estimate” is due to the fact that a company cannot predict the specific receivables that will default in the future.

Given the prevalence of paying on credit in the modern economy, such instances have become inevitable, although improved collection policies can reduce the amount of write-offs and write-downs.

Companies that accept payments on credit must understand the fact that incurring bad debt is now a part of their business model, as it is near impossible to extend credit to customers without exposure to some degree of default risk.

Bad Debt Expense: Recognition on Income Statement

The sale from the transaction was already recorded on the income statement of the company since the revenue recognition criteria per ASC 606 were met.

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).

But under the context of bad debt, the customer did NOT hold up its end of the bargain in the transaction, so the receivable must be written off to reflect that the company no longer expects to receive the cash.

In certain instances, a portion of the owed cash could have been received (e.g. installment payments) until the customer could no longer continue to pay off the remaining amount, the remainder of which would be subsequently written off.

Usually, the recognition of the bad debt expense can be found embedded within the selling, general and administrative (SG&A) section of the income statement.

Bad Debt: Balance Sheet Write-Off: Allowance Method

Following a credit sale, the company awaits the cash payment from the customer, with the unmet obligation recorded as “Accounts Receivable” on the balance sheet.

The accounts receivable (A/R) line item can be found in the current assets section of the balance sheet as most receivables are expected to be taken care of within twelve months (and most are).

The “Allowance for Doubtful Accounts” is recorded on the balance sheet to reduce the value of a company’s accounts receivable (A/R) on the balance sheet.

Since an increase in this account causes its paired asset (i.e. accounts receivable) to decline, the account is considered to be a contra-asset, i.e. the allowance for doubtful accounts is net against A/R to reduce its value.

The allowance is based on management’s best estimate for the bad debt expense – i.e. the dollar amount of receivables that will not be paid by customers – which is calculated using either the aging method or the percentage of sales method, or a combination of the two considering how closely tied they are to each other.

It is important to note, however, that the recorded allowance does not represent the actual amount but is instead a “best estimate”.

The actual bad debt expense can and often does diverge substantially from management expectations, although the gap should close over time as the company matures and management adjusts their estimates appropriately in subsequent periods.

The allowance method is necessary because it enables companies to anticipate losses from bad debt and reflect those risks on their financial statements.

While some might view it as overly conservative, it reduces the chance of steep losses that were unexpected.

In such cases, the share price of the company could exhibit significant volatility in the public markets, which accrual accounting attempts to limit.

Collection of Bad Debt

The cause of the missed payment could be from an unexpected event by the customer and poor budgeting, or it can also be intentional due to poor business practices.

In the latter scenario, the customer might never have had the intent to pay the seller in cash.

If the lost amount is deemed significant enough, the company could technically proceed with pursuing legal remedies and obtaining the payment through debt collection agencies.

However, the odds of collecting the cash tend to be very low and the opportunity cost of attempting to retrieve the owed payment typically deters companies from chasing after the customer, especially if B2C.

For most companies, the better route is to improve their collection processes internally and implement the right procedures to reduce such occurrences.

How to Calculate Bad Debt Expense (Step-by-Step)

Aging Method vs. Percentage of Sales Method

There are two primary methods for estimating the value of bad debt expense:

  1. Aging Method → The accounts receivable aging method consists of sorting the outstanding credit purchases into groups by the number of days they have been due. The groups are most often segmented per 30 days, with each assigned a specific percentage that reflects the company’s estimated probability of receiving the payment.
  2. Percentage of Sales Method → The percentage of sales method can also be used to estimate the bad debt expense. The expense is calculated off of a percentage of revenue assumption, which is based on the company’s historical bad debt expense as a percentage of sales and management’s judgment on the effectiveness of any operating changes it had implemented.

The reliability of the estimated bad debt – under either approach – is contingent on management’s understanding of their company’s historical data and customers.

The assumptions should not simply take the past averages, as a far more detailed analysis must be performed to identify the causes of these uncollectible receivables, patterns among customer behavior, and how the recent operational changes might affect the frequency of such occurrences.

In order words, the approximated figures must be backward-looking and forward-looking, with management remaining conservative per the prudence principle with regard to how effective their operating adjustments will be.

Bad Debt Journal Entry Example (Debit and Credit)

Suppose a company recorded $20 million in net revenue during fiscal year 2021.

Based on the company’s historical data and internal discussions, management estimates that 1.0% of its revenue would be bad debt.

  • Net Revenue = $20 million
  • Bad Debt Assumption = 1.0% of Revenue

The estimated bad debt expense of $200,000 is recorded in the “Bad Debt Expense” account, with a corresponding credit entry to the “Allowance for Doubtful Accounts”.

  • Bad Debt Expense = $20 million × 1.0% = $200k

On the income statement, the bad debt expense is recorded in the current period to abide by the matching principle, while the accounts receivable line item on the balance sheet is reduced by the allowance for doubtful accounts.

The journal entry for our hypothetical scenario is as follows.

Journal Entry Debit Credit
Bad Debt Expense $200,000
       Allowance for Doubtful Accounts $200,000

Bad Debt Provision: Write-Offs of Financial Obligations (Loans)

The term bad debt could also be in reference to financial obligations such as loans that are deemed uncollectible.

For companies that offer debt securities and lines of credit to consumers and corporate borrowers, defaults on financial obligations – akin to irretrievable receivables – are an inherent risk to their business model.

If a customer defaults, the lender is unable to receive the interest expense payments and the original principal at maturity – albeit, the chance of recovering a portion (or the entirety) of the lost amount is possible, particularly for corporate defaults.

Contrary to customers that default on receivables, debt tends to be a more serious matter, where the loss to the creditor is substantially greater in comparison.

In addition, the creditor could have a lien on an asset belonging to the debtor, i.e. the debt was collateralized as part of the financing arrangement.

The accounting methodology for such “bad debt” is relatively similar to that of bad A/R, but the estimate is formally called the “bad debt provision”, which is a contra-account meant to create a cushion for credit losses.

Once the estimated bad debt figure materializes, the actual bad debt is written off on the lender’s balance sheet.

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