Cash flow is the lifeblood of any business so anything that reduces cash flow could jeopardize business success or even its survival. Any company that extends credit to its customers is at risk of slower or reduced cash flow if any of that credit turns into bad debt expense. Although some level of bad debt expense is often unavoidable, there are steps companies can take to minimize bad debt expense.
When a customer defaults on its bills or is in danger of doing so, the company extending credit to that customer faces a bad debt expense. Bad debt expense reflects the amount of accounts receivable that a company is unable to collect now and may not be able to collect in the future. Because this bad debt expense must be charged against the company's accounts receivable, bad debt expense reduces the amount of accounts receivable on the company’s income statement.
There are many examples of companies dealing with bad debt expense. One company changed its approach to bad debt management after two major clients defaulted on their bills, leaving the company facing tens of thousands of dollars in losses. To make matters worse, the company had also dedicated considerable staff time and resources trying to collect on those bad debts with no success. By purchasing credit insurance, the company not only protected itself against future losses from bad debt, but it also was able to leverage that protection as it pursued growth with new customers.
Another company that was growing rapidly, , 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. However, as it grew, the company recognized that it could not eliminate the risk of bad debt expense entirely. It had so many new customers coming on board that it had to evaluate their creditworthiness via third party data and information that did not always provide an accurate picture of a customer’s financial state. Johnstone Supply ultimately decided to purchase credit insurance to reduce its exposure to bad debt expense.
Is Bad Debt an Expense?
A bad debt expense is typically considered an operating cost, usually falling under your organization’s selling, general and administrative costs. This expense reduces a company’s net income over the same period the sale resulting in bad debt was reported on its income statement.
Bad debt expense is calculated as a percentage of total accounts receivable. To calculate bad debt expense, divide the total dollar amount of all accounts receivable by the total dollar amount of bad debt then multiply that number by 100. For example, a company with $1 million in accounts receivable and $50,000 in bad debt would calculate bad debt expense using this bad debt expense formula:
$1,000,000 ÷ $50,000 = .05
To turn that into a percentage, multiply this number by 100:
.05 x 100 = 5%
In this case, the company’s bad debt expense represents 5% of its accounts receivable.
One of the best ways to manage bad debt expense is to use this metric to monitor accounts receivable for current and potential bad debt overall and within each customer account. By setting certain thresholds for current and potential bad debt, a company can take action to manage and prevent bad debt expense before it gets out of hand.
Typically, the allowance method of reporting bad debts expenses is preferred. However, it’s important to know the differences between these two methods and why the allowance method is generally looked to as a means to more accurately balance reports.
When reporting bad debts expenses, a company can use the direct write-off method or the allowance method. The direct write-off method reports the bad debt on an organization’s income statement when the non-paying customer’s account is actually written off, sometimes months after the credit transaction took place. Company accountants then create an entry debiting bad debts expense and crediting accounts receivable.
In general, accounting departments do not use the direct write-off method for bad debts expense, as the company’s balance sheet would be likely to report an amount greater than the actual collectable amount and the bad debts expense may be reported in the company’s income statement for the year after the sale. Instead, accountants typically apply the allowance method.
Using the allowance method, accountants record adjusting entries at the end of each period based on anticipated losses. At the end of each year, companies review their accounts receivable and estimate what they will not be able to collect. Accountants debit that amount from the company’s bad debts expense and credit it to a contra-asset account known as allowance for doubtful accounts.
When accountants ultimately write off an accounts receivable as uncollectible, they can then debit allowance for doubtful accounts and credit that amount to accounts receivable. Using this method allows the bad debts expense to be recorded closer to the actual transaction time and results in the company’s balance sheet reporting a realistic net amount of accounts receivable.
Bad debts are not good for a business. While one or two bad debts of small amounts may not make much of an impact, large debts or several unpaid accounts may lead to significant loss and even increase a company’s risk of bankruptcy. Bad debts also make your company’s accounting processes more complicated and, in addition to monetary losses, take up valuable staff time and resources as they unsuccessfully try to collect on the debts.