The cost of bad debts is recognized when receivable accounts can no longer be collected because a customer cannot meet its outstanding debt obligation due to bankruptcy or other financial problems. Businesses that extend credit to their customers report bad debts as an allowance for doubtful accounts on the balance sheet, also known as a provision for credit losses.
Key takeaways
- Bad debts are an unfortunate cost of doing business with credit customers, as there is always a default risk inherent in extending credit.
- The write-off method directly records the number of specifically identified illegible accounts.
- To comply with the matching principle, the cost of delinquency must be estimated using the provision method in the same period in which the sale is made.
- There are two main ways to evaluate the inadequate debt provision: the percentage-of-sales form and the accounts receivable aging method.
Bad Debt Expenses
Understanding the Costs of Bad Debt
Lousy debt costs are generally classified as selling and general administrative expenses and are included in the income statement. Identifying bad debts reduces the offsetting of accounts receivable on the balance sheet, although companies retain the right to collect funds if circumstances change.
Allocation method by direct cancellation vs. allocation
Two different methods are used to identify the cost of bad debt. Using the direct write-off method, illegible accounts are written off immediately as they become unrecognizable. This method is used in the US for income tax purposes.
However, even though the direct write-off method records the exact number of illegible accounts, it still adheres to the matching principle used in accrual accounting and generally accepted accounting principles (GAAP). The matching principle requires that costs be matched to related revenue in the same accounting period in which the revenue transaction occurs.
For this reason, the cost of bad debts is calculated using the reserve method, which provides an estimated dollar amount of bad debts in the same period in which revenue is earned.
Recording Bad Debt Expenses Using the Allocation Method
The reserve method is an accounting technique that allows companies to include projected losses in their financial statements to limit the overstatement of expected income. To avoid an account overstatement, a business will estimate the number of its accounts receivable from current period sales that it seriously expects to be.
Because no significant period has elapsed since the sale, a business does not know which exact accounts receivable will be paid and which are in default. So, the allocation for the suspicious report is based on the estimated figure.
A business will incur the cost of bad debts and credit this reserve account. The provision for a doubtful report filed against an account receivable is an anti-asset account, meaning it reduces the total value of the accounts receivable when both balances are listed on the balance sheet. This provision may accumulate over accounting periods and be adjusted based on the account balance.
Methods for estimating the costs of bad debts
There are two main methods of collecting the dollar amount of receivable accounts that are not estimated. The cost of bad debts can be calculated using statistical models such as the probability of default to determine expected losses due to bad debts. Statistical calculations can use historical data from the company and the industry. The specified percentage will generally increase as accounts receivable age increases to reflect increased default risk and decreased collections.
Alternatively, the cost of bad debt can be estimated by taking a percentage of net sales, based on the company’s historical experience with bad debt. Companies periodically make changes to the provision for recording credit losses to correspond to the current conditions of statistical models.
Accounts receivable aging method
The aging method groups all outstanding accounts receivable by age, with specific percentages applied to each group. The aggregate of the results for each group is the estimated unreadable amount. For example, a business has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable over 30 days outstanding. Based on experience, 1% of receivables less than 30 days old will not be collectible, and 4% less than 30 days old will be illegible. Therefore, the company will report a bad debt provision and expense of $1,900 ($70,000 * 1%) + ($30,000 * 4%)). If the next accounting period based on outstanding accounts receivable results in an estimated allocation of $2,500,
Sales Percentage Method
The sales method applies a fixed percentage to the total sales volume for the period. For example, based on experience, a business might expect 3% of net sales to be non-collectible. If the total net sales for the period are $100,000, the company establishes a provision for a doubtful account of $3,000 and, at the same time, reports $3,000 in cost of bad debts. If the next accounting period results in a net sale of $80,000, an additional $2,400 are written in the allowance for doubtful accounts, and $2,400 in the second period is recorded in the cost of bad debt. The added balance in reserve for doubtful accounts after these two periods is $5,400.
