#bad debt expense
Generally accepted accounting principles require companies to estimate how much of the money they are owed by their customers will never get paid, and account for that amount in their financial statements. They do this by taking bad-debt expenses and performing write-offs. A bad-debt expense anticipates future losses, while a write-off is a bookkeeping maneuver that simply acknowledges that a loss has occurred.
Drawing on their own experience, a company’s managers should have a general idea how much of the company’s accounts receivable — its customers’ outstanding bills — will ultimately go unpaid. Accounting standards require that companies maintain an allowance for their estimate of those uncollectible bills. For example, if your company’s experience tells you that 1.5 percent of accounts receivable will be uncollectible, and your current accounts receivable balance is $20,000, you should have an allowance of $300. Your balance sheet would show $20,000 in receivables, offset by the $300 allowance, for a net accounts receivable of $19,700.
When a company needs to add to its allowance, it does so by recording a bad-debt expense for the necessary amount. For example, you need an allowance of $300 but currently only have $200 committed to the allowance. You would record a bad-debt expense of $100 on your income statement and increase the allowance by $100, to the new total of $300. Notice that you record the bad-debt expense — and therefore reduce your profit — only in anticipation of customers failing to pay their bills. No debts have actually gone bad yet. This follows the accounting principle of conservatism: A company should never overstate its assets, and failing to recognize that certain customer bills won’t be paid would overstate the value of accounts receivable, which is an asset.
At some point a debt will actually go bad — a customer will fail to pay a bill for long enough that the company concludes that the account is uncollectible. When that happens, the company writes off the debt. For example, you have $20,000 in accounts receivable and a $300 allowance, for a net of $19,700. You determine that a customer who owes you $180 is never going to pay. To write off the debt, reduce both accounts receivable and the allowance by the amount of the bad debt — $180. You now have an accounts receivable balance of $19,820 and an allowance of $120. Net accounts receivable remains the same: $19,700. The write-off doesn’t directly affect your company’s profitability because you’ve already expensed the bad debt. However, you may need to incur a new bad debt expense to replenish your allowance.
It’s possible to underestimate how big of an allowance you need to maintain for uncollectible accounts. It’s also possible that an unusually large debt will go bad, overwhelming the allowance you’ve set aside. In either case, you might end up having to write off an amount greater than the current balance of your allowance. When that happens, you’ll need to immediately record a bad-debt expense to get your allowance caught up, and then write off the bad debt.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.