Doing business on credit has great advantages such as boosting one’s sales and revenues and inviting customers to make spontaneous purchases. But this is fraught with several inherent risks that result in bad debt expenses.
A bad debt expense occurs when one or more of your receivables cannot be collected within the agreed-upon time even after exercising all the options of money collection.
For example, a firm XYZ Limited sold goods worth $400 to ABC Limited. However, XYZ Limited subsequently gets to know that since ABC Limited has gone bankrupt, the chances of recovering the money are nil. Therefore, this $400 becomes a bad debt.
This irrecoverable receivable is considered as a contingency that every business needs to account for.
Why do bad debt expenses occur?
There are several reasons why a business has to deal with these expenses:
- Your customer is unable to pay your money back due to insolvency or bankruptcy.
- The customer is fraudulent.
- When the money collection cost is more than the actual amount of the debt and you decide to let it go.
How are bad debt expenses calculated?
There are two ways of calculating the bad debt expenses of your business, which include:
- Percentage-of-sales method/ Allowance Method: In this method, the uncollectible accounts are estimated from the credit sales in a given period depending on your experience. The formula used here is:
Bad debt expense= Net sales (Total or credit) X Percentage estimated as uncollectible
For example, you estimate your uncollectible at 1% of the total net sales. Your actual net sales for the year were $ 500,000 and the year-end receivables were $ 100,000. As per the formula, you will make an allowance of $ 5,000 ($ 500,000 X 1)
- Percentage of accounts receivable method: Under this method, the uncollectible accounts are calculated by grouping all of them by age and applying specific percentages to each group. The aggregate of all the group results is the estimated amount that’s not collected.
The formula used here is:
Bad debt expense= Account receivable ending balance X percentage estimated as uncollectible)
For example, you have accounts receivable of $ 70,000 less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding. Based on your prior experience, you estimate that 1% of your accounts receivables will not be collected. Therefore, you will report and expense of $ 1,900 ($ 70,000 X 1%) + ($ 30,000 X 1%).
How are bad debt expenses recorded?
Depending on which bad debt expense estimation you use, the recording of these is done in your books:
- Recording under the allowance method: For example, after calculating your percentage of bad debts, you have decided to establish an allowance of $ 2,000. This is how it will be recorded:
|Bad debt expense||$ 2,000|
|Allowance for bad debts||$ 2,000|
Now, if your customer finally tells you that they won’t be able to pay $ 200 since your future losses are already covered by the allowance that you had set, you will record it as:
|Allowance for bad debts||$ 200|
|Accounts receivable||$ 200|
- Recording under the percentage of accounts receivable method: If you have decided to write off $800 that you think will not be collected, this is how you will record it:
|Bad debt expense||$ 800|
|Accounts receivable||$ 800|
For more instructions you can refer to IRS Schedule K1 Form 1065.