What is a bad debt expense?
Bad debts are debts that its no longer possible to collect, in other words, theyre an irrecoverable receivable. There are many different reasons why your business could end up dealing with a bad debt. You may, for example, have extended credit to a customer that wasnt a suitable candidate. Alternatively, your company may have been the victim of fraud. Most commonly, however, bad debts are the unfortunate result of customers becoming insolvent or bankrupt, and simply not being able to pay their bills. To answer that question, youll need to understand a little more about bad debt expense. Read on to learn more. Bad debt expense explained  A bad debt expense is a transaction that you can record in your companys books to account for a bad debt that you no longer have any hope of collecting. By entering a bad debt expense into your accounts, you can ensure that your books accurately reflect your businesss finances and arent making your income appear higher than it really is. Furthermore, it can help to lower your tax bill (since a bad debt expense stops you from having to pay taxes on a profit that you havent made). Direct write-off method vs. allowance method  There are two main ways to record a bad debt expense:  Direct write-off method (also referred to as a bad debt write-off)  Allowance method (also referred to as a bad debt provision or the provision for doubtful debts)  These accounting techniques allow you to deal with bad debts in slightly different ways. Essentially, with the direct write-off method, you simply write bad debts off on a case-by-case basis by recording a bad debt expense in your companys general ledger for the original invoice amount. However, with the allowance method, you account for bad debts ahead of time by creating an allowance (i.e., a silo of cash on your books that you can draw from to pay for any bad debts that you encounter). Generally, the direct write-off method is best suited to businesses that dont do much business on credit, and therefore, arent likely to encounter many bad debts. The allowance method is more suited to firms that extend credit on a regular basis, and as a result, are more likely to experience bad debts. How to calculate a bad debt expense  direct write-off method  Firstly, lets explore how to calculate a bad debt expense using the direct write-off method. Essentially, you need to debit the bad debt expense in your general ledger for an amount equal to the receivable. Then, you credit accounts receivable for the same amount. For example, if youve got an invoice for $1,000 that has been deemed a bad debt, youll need to credit accounts receivable with $1,000 and debit the bad debt expense. The journal entry for this transaction should look as follows:  Account Debit Credit Bad debt expense $1,000 - Accounts receivable - $1,000  How to calculate a bad debt expense  allowance method  Now, lets learn how to calculate a bad debt expense via the allowance method. Basically, youll need to estimate your percentage of bad debts using the following formula:  Bad Debt Percentage = Total Bad Debts / Total Credit Sales  If the figure resulting from this calculation sounds reasonable, create an allowance for the amount indicated by the formula. For example, lets say that over the past year, you made credit sales of $340,000, of which a total of $22,000 ended up being uncollectable. You can work out the bad debt percentage like so:  Bad Debt Percentage = $22,000 / $340,000 = 0.0647 = 6.47%  Now, lets assume that you have $70,000 in credit sales in a particular month. Using the bad debt percentage, you can work out how much your allowance for bad debts needs to be ($70,000 x 0.0647 = $4,529). So, the journal entry for the allowance would look like this:  Account Debit Credit Bad debt expense $4,529 - Allowance for bad debts - $4,529  Now, any future losses are covered by the allowance. So, if a customer then goes bankrupt and is unable to pay their invoice  say, for $800  you can make the following journal entry to record the bad debt expense:  Account Debit Credit Allowance for bad debts $800 - Accounts receivable - $800  We can help  GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.