Bad debts expense is related to a company’s current asset accounts receivable. Bad debts expense is also referred to as uncollectible accounts expense or doubtful accounts expense. Bad debts expense results because a company delivered goods or services on credit and the customer did not pay the amount owed. It is a part of operating a business if that company allows customers to use credit for purchases.

Essentially, bad debt expenses reduce profits while decreasing account receivable balances. Companies classify them as operating expenses since they do not relate to their core activities. It involves recording an expense while reducing the accounts receivable. Therefore, it impacts the income statement and the balance sheet simultaneously. Once recognized, this amount does not appear on the balance sheet as a recoverable balance. On the other hand, under the allowance method, bad debt expense is treated as an operating expense.

Bad debt expense is an operating expense that is recorded in the income statement within the operating expenses section. 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.

How to Record Bad Debts

Businesses that use cash accounting principles never recorded the amount as incoming revenue to begin with, so you wouldn’t need to undo expected revenue when an outstanding payment becomes bad debt. In other words, there is nothing to undo or balance as bad debt if your business uses cash-based accounting. Recording uncollectible debts will help keep your books balanced and give you a more accurate view of your accounts receivable balance, net income, and cash flow. Bad debt expenses make sure that your books reflect what’s actually happening in your business and that your business’ net income doesn’t appear higher than it actually is. Accurately recording bad debt expenses is crucial if you want to lower your tax bill and not pay taxes on profits you never earned.

A good habit is not to over-leverage yourself—for example, overusing credit cards and carrying a high balance. Medical debt, for example, is difficult to categorize as “good” or “bad” debt. This is because it’s a mostly unpredictable expenditure that frequently lacks an interest rate. Debt is a popular term used in various circumstances, not only in business. The amount that can be recovered from a person or entity is called debt. Everything in 2020 changed for organizations, from AR departments having to deal with evolving work environments to low cash flow and more.

One approach is to apply an overall bad debt percentage to all credit sales. Another option is to apply an increasingly large percentage to later time buckets in which accounts receivable are reported in the accounts receivable aging report. Finally, one might base the bad debt expense on a risk analysis of each customer. No matter which calculation method is used, it must be updated in each successive month to incorporate any changes in the underlying receivable information. Usually, bad debts stem from a company’s inefficiency to recover owed amounts from customers. Therefore, companies classify bad debt expenses as operating expenses in the income statement.

6 Operating expenses

While it can be useful for smaller amounts, it can also result in misstating income between reporting periods if bad debt and sales entries occur in different periods. The journal entry for this method is a debit to bad debt expense and a credit to accounts receivable. Goods that have been sold, but not yet paid for, and services that have been performed, but not yet paid for, are recorded in your books as either accounts receivable or notes receivable. After a reasonable period of time, if you have tried to collect the amount due, but are unable to do so, the uncollectible part becomes a business bad debt. Bad debt expense is reported within the selling, general, and administrative expense section of the income statement.

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Often abbreviated as OpEx, operating expenses include rent, equipment, inventory costs, marketing, payroll, insurance, step costs, and funds allocated for research and development. We haven’t posted any other transactions, but you can see we didn’t record the write off of the prior year’s sale as an expense in this year. We already “recognized” the expense in year one when we recognized the revenue from all that work we did.

How to Determine Bad Debt Expense

Bad debt expense is the cost incurred by a company when a customer fails to pay a debt owed. Depending on the method of accounting used, this expense can either be treated as an operating expense or a non-operating expense. Bad debt expense, or money lost due to customers not paying their bills, is not considered an operating expense.

In some cases, companies may recover balances even though they were irrecoverable before. If that occurs, companies must reverse the accounting for bad debt expense. Usually, this process involves creating an income on the income statement. Credit sales allow companies to sell goods or services for future promised payments. Instead, the company sends an invoice to the customer requesting a settlement. In the meanwhile, the company records a receivable balance in its books.

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The allowance method involves estimating the amount of bad debt that is likely to occur and recording it as an expense in the same accounting period as the related sales revenue. This involves estimating uncollectible balances using one of two methods. This can be done through statistical modeling using an AR aging method or through a percentage of net sales.

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