What Is a Bad Debt Expense? Ultimate Guide with Examples

Operating expenses, commonly abbreviated as OpEx, are one type of expense that must be taken into consideration. This category of expenses includes rent, equipment, inventory costs, marketing, payroll, insurance, step costs, and R&D funds. Operating expenses are incurred for the purpose of running the business and generating revenue. BDE is an important part of a company’s financials, as it helps to ensure that the company is accurately reporting its financial performance. While the actual cost of the bad debt is not typically included in a business’s COGS, it’s important to factor in when calculating profits and losses.

However, it does not guide companies on whether it should be a part of operating expense or the cost of sales. Under the direct write-off method, bad debt expense is treated as a non-operating expense. This means that it is not directly related to the company’s day-to-day operations.

When your business decides to give up on an outstanding invoice, the bad debt will need to be recorded as an expense. Bad debt expenses are usually categorized as operational costs and are found on a company’s income statement. The allowance method is an alternative technique used to estimate uncollectable receivables.

Unlike the allowance method, there is no estimation involved here as the company specifically choose which accounts receivable to write off and record bad debt expense immediately. Likewise, the company may record bad debt expense at any time during the period. A bad debt expense can be estimated by taking a percentage of net sales based on the company’s historical experience with bad debt. This method applies a flat percentage to the total dollar amount of sales for the period. Companies regularly make changes to the allowance for doubtful accounts so that they correspond with the current statistical modeling allowances. This can be done through statistical modeling using an AR aging method or through a percentage of net sales.

Thus, such a debt expense is usually recorded as a bad debt loss on the company’s income statement. Journal entries are more of an accounting concept, but they can record your doubtful debt mergers & acquisitions m&a valuation expenses. It’s recorded when payments are not collected or when accounts are deemed uncollectable. Most users wonder if bad debt is an expense since it reduces account receivable balances.

Companies should estimate a total amount of bad debt at the beginning of every year to help them budget for that year and account for non-collectible receivables. 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.

The latter is an account that includes receivable balances that may be irrecoverable. Usually, companies record these based on their past experiences with customers. However, these do not constitute an actual reduction in accounts receivables.

What is a Bad Debt Expense and How to Protect Your Business

Bad debt is an amount of money that a creditor must write off if a borrower defaults on the loans. If a creditor has a bad debt on the books, it becomes uncollectible and is recorded as a charge-off. Bad debt is a contingency that must be accounted for by all businesses that extend credit to customers, as there is always a risk that payment won’t be collected.

• Under the direct write-off method, the company calculates bad debt expense by determining a particular account to be uncollectible and directly write off such account.
• This means that it is not directly related to the company’s day-to-day operations.
• The latter is an account that includes receivable balances that may be irrecoverable.
• Read on for a complete explanation or use the links below to navigate to the section that best applies to your situation.

Therefore, companies classify bad debt expenses as operating expenses in the income statement. Therefore, it impacts the income statement and the balance sheet simultaneously. Once recognized, this amount does not appear on the balance sheet as a recoverable balance. On the other hand, under the allowance method, bad debt expense is treated as an operating expense.

Allowance Method

The allowance method estimates bad debt expense at the end of the fiscal year, setting up a reserve account called allowance for doubtful accounts. Similar to its name, the allowance for doubtful accounts reports a prediction of receivables that are “doubtful” to be paid. The direct write-off method involves writing off a bad debt expense directly against the corresponding receivable account. Therefore, under the direct write-off method, a specific dollar amount from a customer account will be written off as a bad debt expense. Using the direct write-off method, uncollectible accounts are written off directly to expense as they become uncollectible. On the other hand, the allowance method accrues an estimate that gets continually revised.

Such limits can be set to manage existing and potential bad debt expense overall and for specific customers. 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. Under this method, we find the estimated value of the bad debt expense by calculating bad debts as a percentage of the accounts receivable balance. They argue that it is a mistake to classify this expense as a non-operating one because it is recorded on the cash flow statement and affects its cash position. Another argument favoring classifying bad debt as a non-operating expense is that bad debt comes from lending money to their customers, and they are unlikely to get it back.

#2. Allowance Method

It is the expense incurred by the business while engaging in its routine activities. It is the expense incurred by the business while engaging in its primary business activities. Operating expenses are the expenses that arise from daily, core operational activities conducted by a company. Typically, they’re tax deductible as long as a company operates to earn a profit, expenses are commonly known, and necessary.

Selling to clients on credit always comes with the risk of them not paying you back on time. QuickBooks has a suite of customizable solutions to help your business streamline accounting. From insightful reporting to budgeting help and automated invoice processing, QuickBooks can help you get back to the daily tasks you love doing for your small business. When you sell a service or product, you expect your customers to fulfill their payment, even if it is a little past the invoice deadline. Allowance for Bad Debts (also often called Allowance for Doubtful Accounts) represents the estimated portion of the Accounts Receivable that the company will not be able to collect.

What are the Benefits of Factoring Your Account Receivable?

Instead, it is considered a loss that is incurred due to the failure of a customer to pay their debt. Either net sales or credit sales method is acceptable in the calculation of bad debt expense. However, if the credit sales fluctuate a lot from one period to another, using the net sales method to calculate bad debt expense may not be as accurate as using credit sales. A non-operating expense is an expense incurred by a business that is unrelated to the business’s core operations. The most common types of non-operating expenses are interest charges or other costs of borrowing and losses on the disposal of assets. Accountants sometimes remove non-operating expenses to examine the performance of the business, ignoring the effects of financing and other irrelevant issues.

Bad debts end up as such because the debtor can’t or refuses to pay because of bankruptcy, financial difficulty, or negligence. These entities may exhaust every possible avenue to collect on bad debts before deeming them uncollectible, including collection activity and legal action. However, because there are reasons other than insolvency for customer nonpayment, this type of bad debt account protection is of limited use for most companies. Companies can obtain bad debt account protection that provides payment when a customer is insolvent and is unable to pay its bills.

Definition of Bad Debts Expense

BDE helps companies manage their credit risk by providing them with a better understanding of their accounts receivable. By recording BDE, companies can identify areas where they need to improve their credit policies and processes. Though calculating bad debt expense this way looks fine, it does not conform with the matching principle of accounting. That is why unless bad debt expense is insignificant, the direct write-off method is not acceptable for financial reporting purposes. Allowance for bad debts (or allowance for doubtful accounts) is a contra-asset account presented as a deduction from accounts receivable.

Therefore, companies cannot put this expense under the cost of goods sold. Good financial management of operating expenses can help a business achieve profitability and sustainability. Companies should focus on reducing operating expenses and improving efficiency in order to maximize profits. This can lead to decreased profitability and missed opportunities to grow the business. The company had the existing credit balance of $6,300 as the previous allowance for doubtful accounts. Bad debt is an operating expense because it is the amount not recoverable from the borrower during the day-to-day functioning of the business.