Calculating Bad Debt Expense
In the world of business, a “bad debt expense” is simply an outstanding receivable that is not looking like you’ll be able to be collected on because a customer or client simply cannot fulfill that obligation to make good on the outstanding debt for a variety of different reasons.
Different classifications of bankruptcy protection and other financial issues may stop a customer or client from being able to continue paying on this financial obligation, but any company that extends any form of credit to a customer has to be reporting and accounting for bad debt possibilities in their financial statements.
This is sometimes called a provision for credit losses or an allowance for accounts doubtful to pay you back any longer, but at the end of the day it is a major piece of the corporate financial puzzle and something you are going to have to anticipate and account for if you are to have any success in business going forward – while offering credit to your customers, of course.
Calculating bad debt can be a little bit tricky if you haven’t ever had to do this in the past, but with the rest of the details in this quick guide you shouldn’t have any trouble tackling this in the future. Armed with the inside information we share below you will be able to quickly and efficiently calculate potential bad debt for your operation, giving you a much better, much more accurate, and more complete picture of your company’s finances going forward.
Let’s dive right in!
Classifying Bad Debt Expense
The first thing you’ll need to do when learning how to calculate bad debt expense is figuring out how you are going to classify this on your balance sheet and in your income statements.
The overwhelming majority of companies out there follow the standard accounting practice of classifying bad debt expenses under the “sales & general administrative expense” – a calm you’ll find on your income statement.
This gives you the ability to recognize that bad debts inevitably lead to an offsetting production to your accounts receivable, on your balance sheet, even if your business continues to retain the rights to collect on those outstanding funds if the circumstances surrounding this situation change in your favor.
To keep things simple, it’s a good idea to keep this expense classifying on your income statement as a sales &general administrative expense. It’s really easy to manage, easy to modify, and easy to adjust as necessary later down the line when you take this approach.
Direct Write Off Versus the Allowance Methodology
The next thing you’ll need to figure out when learning how to calculate bad debt expenses is how door actually going to go through the process of calculating these facts and these figures.
There are a couple of distinct methods that are usually taken advantage of when looking to recognize losses on credit for your company. You have the direct write off version and the allowance methodology, one of which may be better suited to your specific situation but it’s important to understand how they both work so that you know how to move forward.
The direct write off method is particularly useful when you’re looking to calculate bad debt for purposes of income tax in the United States. With this approach you’ll write off uncollected amounts of debt as they become uncollectible and not beforehand.
The downside here is that while you are able to keep pretty accurate books as far as your uncollectible debt is concerned (and the EXACT amounts of that debt), you won’t be able to stick to the matching accounting principle that is most traditionally used in accrual style accounting as well as the most common Generally Agreed Accounting Principles (GAAP).
These rules dictate that any expense has to be recognized just as soon a transaction happens as opposed to when a payment has been made. To make sure that you are in line with these principles a lot of companies decide to go with the allowance methodology – a methodology that allows for estimated dollar amounts of uncollected accounts during that same specific accounting period.
Using the Allowance Methodology to Calculate Bad Debt
As we highlighted just a moment ago, this specific approach is going to be used to calculate an estimated figure for bad debts and uncollectible accounts during a specific accounting timeline in which revenue has been earned/generated.
The trouble here is that because there hasn’t been a significant amount of time passing before each individual sale (on credit) has been made it impossible for a company to know which accounts are going to default, which accounts are going to be paid, and which accounts are going to eventually pass into the uncollectible debt category.
With the allowance method, you are generally creating an open allowance for potential credit losses based off of anticipated credit default for your business. The allowance is established based off of this aspirated figure, and companies are going to debit the bad debts expense and then credit this allowance to make sure everything is Even Steven and on the up and up.
This specific allowance is going to be classified as a contra asset account within your accounts receivable set up there this means that it is going to generally reduce the overall loan receivable account that you have when all of your balances have been listed across the balance sheet. It’s also possible for this account to accumulate over time, and even stretch across accounting periods, while being adjusted accordingly based upon the running balance you keep in this contra asset account.
Statistical models for individual industries are usually leveraged as the backbone for figuring out how to calculate bad debt expense, particularly if your company hasn’t been around long enough to have enough accounts to default in the first place to get a feel for your business average.
Historical data from all over your industry can be cultivated pretty quickly, but you’re also going to want to go to work creating your own individual historical data so that you can adjust as necessary to create bad debt expense allowances that are more in line with your actual experience.
It’s likely that the specific percentage you come up with is going to increase over time, particularly as the age of the individual receivables increase. This reflects the overall default risk that you are facing as well as the decreasing odds of being able to collect altogether, but again that’s something that you are going to have to piece together and figure out as you move forward.
You also have the opportunity to calculate bad debt expense by looking at a percentage of your net sales and then trying to figure out a rough “ballpark” figure of those sales on credit that are most likely to default. Again, you want to inevitably end up analyzing your own data to figure out exactly how close you are and how your bad debt expense allowance should be adjusted – but this is a great start for anyone that is serious about making sure that their books are as accurate as possible.
Have Professionals Help You Set This up
It really should go without saying that something as important as figuring out how to calculate bad debt expense should be left to professional accountants, particularly those that already have their CPA and have been performing these kinds of calculations for years and years already.
This is a major piece of your business’s financial puzzle, particularly if you do a lot of business extending credit to your customers and to your client. You’ll want to make sure that all of your facts and figures are coming together correctly, that you have as complete a picture of your business finances as possible, and that you are accurately recording this data so that you know when to aggressively go after collectible debts and went to recognize uncollectible debts that need to be adjusted on your books.
Professional accountants will be able to begin calculating these facts and figures for you equally but will also be able to gain access to the historical industry/business data you might need to take advantage of if your operation is still quite new. There are plenty of reasons to have these experts helping you every step of the way, the biggest reason is because you – as an entrepreneur – are going to have so many other individual responsibilities for your business that you don’t want to spread yourself too thin.
By all means learn as much as you can about how to calculate bad debt expense with the help of the inside information we shared about, if for no other reason than to fully understand exactly what this important accounting principle means and how it applies to your business.
But lean on the help of professional accountants as often as you can to help you really nail this core principle, make it a big part of your business reporting, and leverage this kind of data and analytics to improve your overall finances and your business’s financial future!