How To Calculate Bad Debt Expense Correctly?
If you have a company or run a small business, you should have different payment terms to accommodate your clients. Some customers might be willing to pay for the item in full, while others will request to pay in instalments. These flexible payment options play an important role in increasing the number of consumers willing to purchase your products again. One of the most common payment methods is instalments or debt. Once an individual has been sold goods on credit, they are expected to pay the amount per the agreement. If this does not happen, the seller is likely to incur a loss.
In most cases, the seller will persuade the buyer to pay the debt. If the buyer refuses or cannot pay, the seller considers this money uncollectible and it is what we term as bad debt.
If you have given up collecting the money, it will not need to stay in the company accounts. The bad debt is removed from the company’s accounts by recording it as an expense. This is called a bad debt expense.
This article will detail what a bad debt expense is and how you can find it on the financial statements. It will also analyse how you can record them in your bookkeeping records.
What Is a Bad Debt Expense?
As mentioned earlier, bad debt is the amount you have given up on collecting from the buyer. Therefore, a bad debt expense is a financial transaction you make on the accounting books to indicate all the bad debts that you have incurred in the process of selling your products.
Bad expenses will not always be recorded because some accounting rules have to be followed.
The bad debt expense can only be recorded in a situation where you use the accrual accounting principles. However, this does not mean that the debt is not bad if you use other accounting methods.
For instance, if you use the cash accounting principle, it is not important to record the debt as an expense because you did not record the amount as revenue. Therefore, a bad debt expense will not be necessary because there is no reversal to make. A bad debt expense is made to reverse the revenue that had been recorded during the sale of the product.
Why Record the Bad Debt Expense?
1. If your company’s income appears higher than it actually is, you might get the wrong impression. Many companies have suffered tremendous losses due to this era. For instance, a company might believe that it is making huge sales and, therefore, stop being aggressive with its marketing campaigns. This means that its products will not reach many consumers as expected, and in the real sense, the company might end up making losses.
It is important to record the exact amount of revenue made because it will help the company with its strategic plans.
2. As well, the amount of tax paid depends on the amount of revenue recorded by the company. If the company is recording high profits, it will have to pay a high amount of tax. You do not want your business to pay taxes on profits that it does not have.
It is necessary to correctly record the bad debt expense to lower the tax bills within a fiscal year.
Recording bad debt will also help companies to avoid similar situations in the future. For instance, if the customer refuses to pay due to a disagreement regarding the quality of the product, the company will find it easy to avoid such customers in the future.
This will reduce the amount of bad debt that can be incurred in the future.
Finding the Bad Debt Expense
A bad debt expense is similar to other expenses incurred in the business, and therefore, it will be located in the general ledger. In the income statements, you can find the bad debt expense under the selling, general and administrative costs (SG&A). The bad debt expense is recorded in this section because it is treated as one of the operating costs.
Calculating the Bad Expense Debt
In some cases, the bad debt might be too high to the extent that the company cannot keep track of it. The good news is that different methods make it easy to calculate this expense. The commonly used methods are allowance, writing off the accounts receivables, and the accounts receivable aging method.
The allowance method
If most of your business transactions are based on credit, it is important to consider bad debts in advance. The allowance method is your ideal choice for calculating these expenses. This method involves establishing a provision for bad debts. This is also called a reserve for doubtful debts.
Reserve is the amount drawn to pay for bad debt expenses that may occur in the future. The possibility of bad debts is high, so it is important to prepare for it. If you are not prepared to pay this fee, your business is likely to suffer huge losses and may eventually go bankrupt.
What is the exact amount that should be set as a reserve to cover bad debt expenses? This is one of the questions many people ask themselves how to calculate bad debt charges. Most companies use the bad debt percentage formula to determine the amount of provision for bad debt.
Bad debt percentage formula
The amount of the reserve should be set before bad debts occur, so it is always an estimate. This percentage is obtained by dividing past debt by past credit sales.
Once you have obtained the percentage of bad debt, you will use it to determine the amount of bad debt that might be incurred in the current year. The fact of whether an individual will pay their debt is not easily predictable, and therefore, the amount of bad debt cannot always be predicted correctly. In some cases, the reserve amount will be high, and in other cases, it will not be enough to cover the debts incurred.
The bad debt expense for the current year is estimated by multiplying the bad debt percentage by the projected credit sales.
If you have not been in business for many years, this method might be highly unreliable. It is ideal for use by people in business for a long time because they have managed to create a pattern. If a huge debt is also distorting the percentage of debt that has been incurred over the years, it will be challenging to rely on it in estimating the bad debt expense.
Writing off accounts receivables
This method is highly reliable when a business does not incur a lot of bad debts. This enables businesses to write the debts off one by one. The writing off is done once the company is certain that the company will not pay. It is easy for businesses to keep up with the number of bad debts in such a case.
The business has to record a simple transaction in its ledger account. The bad debt expense recorded is equal to the value that was recorded on the account receivable.
According to the IRS, a bad debt should only be recorded once it has been made clear that the debt will never be paid. In that case, you need to demonstrate that you have taken all measures possible to recover the amount of no success. If you have been unable to contact the buyer or arrange a repayment plan with them, it means that they will never pay the debt. Therefore, you can write it off as a bad debt.
Accounts receivable aging method
The method involves grouping the receivable accounts based on their age, and a percentage is assigned depending on the likelihood of collecting. Therefore, it is ideal for companies that have been in business for a long time and have created a specific pattern in their accounts receivables. The percentage is estimated based on the businesses’ previous history of debt collection.
If a company is to account for bad debt, it has to be sure about the exact amount incurred in debt. The estimated percentage is multiplied by the total amount of the receivable accounts during the specified time range, and the amount is added to determine the total bad debt expense. This method might not be 100% effective because it relies on estimations. During some periods, a huge debt might make it challenging to predict the future bad debt. In such a case, the business might be required to make unreliable plans.
How Is the Bad Debt Expense Recorded?
Once a bad debt has occurred, or you predict that it will occur, it is important to record it because it will help in planning for the future. The recording can be done using two strategies. The first strategy is writing off bad debts as soon as they occur. The second strategy is determining the amount to be kept as a reserve for the bad debt.
1. Write- off method
As mentioned earlier, this debt is recorded when all efforts to make the customer pay the debt have failed. The bad expense debt is recorded as a debit, while the accounts receivable is recorded as a credit. This recording will cancel out the debt on the balance sheet. Therefore, it will not appear that the company made a loss.
However, this method could result in the misstating of income in different reporting periods. This occurs when the bad debt entry is made in a journal from a different period as the sales entry. In most cases, businesses would take a long time trying to collect a debt, which means the transactions will be recorded in different journal entries. This situation is only permitted when recording an amount that does not have a huge significance to the company.
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2. Recording for the allowance method
As explained earlier, the allowance method involves a prediction of the doubtful debt to determine a reserve amount. This amount is determined at the end of the fiscal year as the business plans for the current year. The company sets up an account known as the allowance for doubtful accounts. This account reports the amount that is predicted to be the total of the bad debt. The amount to be recorded in the accounts is determined using the percentage of sales or the account receivable aging method. The allowance for the doubtful account is recorded on the debit side while the credit is made on the accounts receivable.
FAQs
How is a bad debt expense defined?
A bad debt expense is defined as the measure of the uncollectible debt incurred in a company during a specific accounting period. Uncollectible debt is the amount that buyers are unable to pay or have refused to pay. If the business is unable to collect this amount, it is determined as a bad debt expense. The chances of businesses experiencing bad debt expenses are high due to the unpredictable nature of consumers. If customers are unhappy about a product, they might choose not to pay for it, and the business will incur a bad debt.
How do you budget for bad debt?
Budgeting for bad debt varies from one company to another. It also depends on the type of calculating and recording the bad debt expense used by the business. Some companies choose to write off the debt, thus incurring a loss. Other companies keep a reserve amount to cater for the expenses that will be caused by bad debt. Different methods are used to estimate the uncollectible debt. Among such methods is an allowance, writing off the accounts receivables, and the accounts receivable aging method. Once the amount has been determined, one can budget for the bad debt expense by setting a reserve amount, thus preventing the company from incurring a loss.
How do we calculate bad debt expenses?
Bad debt is calculated through an estimation method. The method used includes allowance, writing off the accounts receivables, and the accounts receivable aging method. The allowance method is based on a reserve that has been set aside to cover bad debt expenses. The write-off method involves writing off each bad debt as soon as it occurs. The accounts receivable aging method is based on accounts receivables from different ages. The total amount of estimated debt from each account receivable is the total debt. This amount is calculated using the percentage of debt formula.
Can bad debt harm businesses?
Bad debt can be highly damaging to a business, especially if it occurs frequently. Bad debt is considered a cost incurred by the company. Given that the cost does not facilitate returns like other costs, it can highly damage the business. If you cannot collect your debts on time, it will limit your cash flow, which will make it challenging for you to carry out the business's daily activities.
Given the uncertain nature of consumers, every business ought to be prepared for a bad debt expense. The chances are high that some customers will not pay for the products, creating a bad debt. The reasons people choose not to pay for products vary from one person to another. Some people choose not to pay debts because they can no longer afford the amount. Other people might have issues with the product and, in turn, choose not to pay for it. In other cases, the person might decide not to pay the amount not because they cannot afford it but because they are unwilling to pay.
Regardless of why your customers fail to pay their debts, you need to be prepared on how to cover the expense. If you plan to remain in business for long, it is advisable to use the allowance method. This method will allow you to set aside an amount to cover the loss incurred through the bad debt. This means the loss will not drive you out of business. In some cases, the debt might be too high to the extent that the business cannot continue with operations unless it seeks external funding. You do not want your business to achieve such a situation, and therefore, it is important to plan how to deal with bad debts in advance.
If you have a small business that is not prone to many debts, the write-off method is ideal for you. This method will allow you to write off debt whenever you seem fit. However, the method is not ideal for large businesses that might incur large amounts of debt.
Conclusion
Regardless of your business’s size, it is advisable to understand how to calculate bad debt expenses. This will help you save your business from the adverse impact of bad debt. The earlier you plan, the better it is for your business.