Despite their best intentions, many businesses end up with some bad debts. Learn how to use the bad debt expense formula.
To calculate the percentage of bad debts, divide your total of bad debts by the total of credit sales. As with any percentage, multiply the result by 100 to get the percent instead of a decimal representation.
Read on to see examples of calculating bad debt expense percentages as well as everything else you need to know about including bad debts in your books.
How to Calculate Bad Debt Expense With Accounts Receivable
Bad debt is something that you don't want to see on your accounts, but it is a fact of life for any company that sells products on credit. Learn how to calculate the bad debt expense, what the figure tells you, and more.
Understanding Bad Debt
As a refresher, bad debt is the balance that clients owe you and you do not anticipate being able to collect. At this point, you have made a reasonable effort to collect the debt and don't see a future where the client pays, or you are reimbursed in another way.
Most companies will write these bad debts off as an expense. After all, you paid to provide the goods or service, which is an expense. But you were not reimbursed via payment.
When Does It Become Bad Debt?
One of the big questions when it comes to bad debt is when you consider the debt to be "uncollectable."
Luckily, the IRS provides clear guidance on this. They say that you only consider its bad debt and write it off once you have no chance at all that you will receive the amount owed. The IRS may ask you to show that you've already gone through "reasonable steps" to try to collect the debt.
In practical terms, this means that if you have already tried to reach the customer to set up a payment plan, you can probably consider it bad debt.
Most companies will consider classifying something as bad debt after 90 days and multiple attempts at contacting the client.
You Only Record Bad Debt With Some Accounting Principles
It is worth noting that while bad debt is always a negative for your business, you only have to record it with accrual accounting.
With cash accounting, you only record revenue once you receive it, not at the time of the order. Because you never received the cash, you wouldn't have recorded it, so you don't have to reverse it via an expense.
With accrual accounting, however, the debt in question would already appear on your books. Therefore, you need the bad debt expense to counter this. Otherwise, your books will not be accurate.
Why Bad Debt Occurs
There are numerous reasons that bad debt can occur, including:
- The customer faces a financial hardship after ordering
- The customer is not happy with the service or product, so they refuse to pay
How to Calculate Bad Debt Expense Formula
There are several ways of calculating your bad debt expenses, but doing so as a percentage is among the most popular.
Bad Debt Expense Formula
As mentioned, the most common method of calculating bad debt is via the expense formula that delivers a percentage of your sales that are bad debt.
The formula is simple:
Bad debt percentage = (Amount of bad debt)/(Amount of total sales) x 100
Consider the following simple example with figures designed to be simple and on a small scale. Assume that your company calculates $30 of bad debt and has total sales of $1,000. To calculate the bad debt percent, you would do the following:
(30/1,000) x 100 = 3.00
So, your bad debt would be 3%.
Use the Percentage of Accounts Receivable or Percentage of Sales
There are two approaches to calculating percentages of bad debt. One is to look at the accounts receivable, while the other looks at the sales.
The difference simply refers to which specific numbers you look at when calculating the bad debt. You can also use either of these when calculating your bad debt allowance, which we will discuss in more detail.
But You Don't Always Know How Much Debt Is Bad
This method is incredibly simple, making it appealing.
The issue, however, comes from the fact that you don't always know what amount of debt is bad debt. After all, it doesn't usually become clear that you can't collect the debt until a fair amount of time has passed following the sales.
In the meantime, using the above formula will not give you accurate results on your balance sheets.
The Allowance Method
The allowance method accounts for this uncertainty, helping you with your balance sheet. The fact that it lets you reconcile your accounts sooner makes it incredibly popular.
The allowance method assumes that you will not be able to collect all of the debt. You create an allowance for that bad debt. This allowance goes by several names, including:
- Allowance for doubtful accounts
- Bad debt provision
- Bad debt reserve
Calculating Your Bad Debt Allowance
There is not typically a set formula for calculating your bad debt allowance. Instead, most companies will look at past calculations using the percentage model above. Then, they will compare that to the current market conditions and make minor adjustments.
Unsurprisingly, this method is not always the most accurate. It can be especially problematic if you have a single large bad debt (or several). It can also be challenging if your company is still relatively young, as you likely don't have much data to go off of.
Methods of Writing Off Accounts Receivable
Whether you use the percentage calculation or a bad debt allowance, you will need to write the bad debt off in your accounts receivable at some point.
With the Allowance Method
Larger companies that are more likely to have a larger debt will likely just use the allowance method. They will simply incorporate the bad debt reserve into their budget. In this case, your bad debt is considered a contra-asset account. As such, it appears on the balance sheet with other asset accounts.
Most companies will do this at the end of each month. At this time, you would list the full allowance as a bad debt expense under debits and the allowance for bad debts under credits. Then, when a bad debt occurs, you can write it off and list it as an allowance for bad debts under the debit column and as accounts receivable under the credit column.
With the Direct Write-off Method (Case by Case)
By contrast, smaller companies with minimal bad debt may take a case-by-case approach. With this method, you would simply write off each bad debt as an expense once you decide it is bad debt.
With this method, you will not have a contra-asset account where you record the debt expenses. That means that you have to report the balance on your balance sheet.
In this case, you would list the bad debt expense under debits and accounts receivable under credits.
But This Doesn't Meet All Accrual Accounting Principles
It is worth mentioning that this method is not perfect.
It does not follow the matching principle from accrual accounting. It also doesn't uphold the principles of GAAP.
That is why many smaller companies or businesses with minimal bad debts will still use the allowance method.
Why Should You Calculate the Bad Debt Expense?
It makes logical sense to track your company's bad debt expense, as you need to balance your accounting books.
But looking at the bad debt expense, both in terms of raw numbers and percentages, can do more than just balance your accounts.
To start, having balanced accounts lets you track your company's financials accurately. You will have a more accurate idea of how much you have to spend and your profit margins.
This is crucial for transparency as well. You want to report accurate figures to executives, shareholders, and board members.
Additionally, including bad debt expenses on your books ensures your profits are accurate, not inflated. This is important for filing your taxes, as it ensures you don't pay taxes on profits you never received.
The numbers, or the trends in them, can tell you a lot about how your company is doing. For example, if you notice the percentage of bad debt is rising, this is a warning sign that you need to find the source of the issue and correct it.
Getting in the practice of identifying bad debt also helps you spot customers that have defaulted more times than others. You could use that information to decide if you still want them as a client. Or you can do the opposite and offer clients who consistently pay on time a discount to encourage their business.
Bad debt refers to the money that your clients owe you that is unlikely to be repaid. You must have already taken "reasonable" steps to collect payment before classifying it as bad debt. Depending on your accounting method, you will have to write off the bad debt as an expense on your balance sheet. Regardless of your accounting method, you will need to calculate bad debt to ensure you have accurate figures about your company's finances.
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Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.