How to calculate bad debt expense and reduce financial risk?

Many small businesses depend on trade credit to keep their operations running, with nearly 40% of U.S. companies using it for B2B transactions. 

However, when a business offers credit to its customers, there’s always a risk that some of those debts won’t be paid. These unpaid debts are known as bad debts. 

For instance, you might have extended credit to a customer who wasn’t financially stable, or perhaps your company fell victim to fraud. 

Often, bad debts occur because customers become insolvent or go bankrupt and simply can’t pay their bills.

But, what happens when you’re stuck in a loop with bad debt? How do you minimize it? 

To tackle this challenge, it’s essential to understand what bad debt expense is and how it affects your business. 

Read on to know more.

What is bad debt expense? 

Bad debt expense is an accounting entry you make in your financial records to account for any debts your business has decided it won't be able to collect.

Mainly, this is an issue mainly for businesses that sell on credit and use accrual-basis accounting. 

In this method, revenue is recorded when it's earned, and expenses when they’re incurred, even if the actual payment hasn't happened yet. 

This can lead to situations where a business recognizes revenue before receiving the cash, and later, the customer doesn’t pay. Bad debt expense accounting helps businesses adjust for these uncollectible amounts.

To avoid unexpected financial hits, many companies estimate a reserve for bad debts based on experience. 

For example, if a company sells $5,000 worth of products on credit and expects that 3% might not be paid, it would set aside $150 as a reserve. 

This way, if some customers fail to pay, the loss is absorbed by the reserve without impacting the profit and loss statement.

What causes bad debt expense?

Bad debt arises from various issues that can prevent customers from paying their bills. 

Identifying these causes can help businesses take proactive steps to minimize it and optimize working capital.

1. Disconnected accounting: Lack of coordination between the accounts receivable (AR) department and other business units can lead to invoicing errors and delays. This miscommunication increases the likelihood of disputes and uncollected payments.

2. Disagreements: Billing disputes are a common cause of bad debt. If customers believe they were overcharged or incorrectly billed, they might refuse to pay. The longer these disputes go unresolved, the less likely payment becomes.

3. Lack of timely financing: When customers face cash flow issues and cannot secure financing in time, they might delay or miss payments. Businesses can consider solutions like invoice financing to bridge cash flow gaps and reduce the impact of delayed payments.

4. Bankruptcy: Customers who declare bankruptcy are often unable to meet their payment obligations. It's important to assess a business’s creditworthiness before extending a significant line of credit.

5. Poor communication: Misunderstandings about payment terms, such as unclear invoice deadlines, can lead to delayed or missed payments, increasing the risk of bad debt.

Learn how to master your cashflow with invoice financing.

Why is reporting bad debt expenses important for your business?

Tracking bad debt expenses is essential for several key reasons:

1. Accurate financial reporting: It ensures that your financial statements truly reflect your business's profitability by accounting for potential losses from uncollectible receivables, offering a more accurate view of financial health.

2. Cash flow management: Bad debt can impact your cash flow since it's money you expected but didn’t receive. Keeping track of bad debt expenses helps protect your company’s liquidity and overall sustainability.

3. Risk management: Monitoring bad debt reveals how well your accounts receivable process is working. High levels of bad debt may indicate a need to improve billing and collection processes to reduce future risks.

4. Budgeting and forecasting: By accounting for potential uncollectible, tracking bad debt helps in more accurate revenue forecasting and budgeting, preventing overestimation of income.

5. Tax benefits: Bad debt is recorded as an expense, reducing your taxable income. This tracking ensures compliance in financial reporting and helps balance your books accurately.

How to calculate bad debt expense?

There are two main methods to calculate bad debt expense: the direct write-off method and the allowance method. 

The first is typically used for tax purposes, while the latter is the standard approach in accrual accounting.

1. Direct write-off method

The direct write-off method involves directly removing an unpaid invoice from accounts receivable when it's clear that the customer won’t pay. 

In this case, the amount is charged as bad debt expense. 

This method doesn’t use an allowance account, which is one of its drawbacks. 

While it accurately reflects the amount of uncollectible debt, it doesn’t align well with GAAP (Generally Accepted Accounting Principles, used in the U.S.), particularly the matching principle in accrual accounting. 

According to the matching principle, expenses should be recorded when the related revenue is recognized, not necessarily when payment is made. 

As a result, using the direct write-off method can lead to an overstatement of accounts receivable on the balance sheet.

2. Allowance method

The allowance method involves estimating bad debts before they happen. A company sets up an allowance for doubtful accounts, which represents the estimated amount of receivables that may not be collected. 

This allowance is a contra-asset account (records and offsets any loss in asset value listed in the balance sheet). 

In this case, it reduces the total accounts receivable balance, which the company does not expect to collect.

At the end of the year, the allowance for doubtful accounts is adjusted as needed. This correction is made by debiting the bad debt expense account and crediting the allowance for doubtful ones. 

If a specific receivable is identified as uncollectible, it's written off by debiting the allowance account and crediting accounts receivable.

If, at some point, a previously written-off account is collected, the write-off is reversed. This means the allowance account is credited, and the accounts receivable account is debited, restoring the balance.

The allowance method is preferred in accrual accounting because it aligns with the matching principle and provides a more accurate representation of the company’s financial health.

Debt to equity ratio is one of the metrics to analyze a company’s financial health. Learn how to calculate it.

How to record bad debt expense: Formulas & examples

1. Using the direct write-off method

In this approach, you record the bad debt by debiting the bad debt expense and crediting accounts receivable for the same amount.

For example, if you have an invoice for $1,000 that you’ve decided is uncollectible, you would credit accounts receivable for $1,000 and debit the bad debt expense for the same amount. 

The journal entry for this transaction would look like this:

This entry reflects the removal of the uncollectible amount from your accounts receivable and recognizes the loss as an expense in your books.

2. Using the direct write-off method

When it comes to calculating bad debt expenses, businesses have a few different methods at their disposal. These estimates are much more accurate when they’re based on historical data regarding bad debts.

Percentage of sales method

This approach estimates bad debt expense by taking the company's total revenue for the current period and multiplying it by the historical percentage of revenue that typically goes uncollected. 

For instance, if a business generated $1 million in sales during the current period and historically, 5% of revenue remains uncollected, it would record a $50,000 bad debt expense. 

This entry would be made in the contra-asset account, and the net revenue on the profit and loss statement would be $950,000. 

Formula:

Percentage of sales = (Estimated uncollectible sales x Total sales) / 100

Percentage of receivables method

For businesses that deal with both credit and cash sales, the percentage of receivables method provides a more accurate estimate of bad debt. 

Instead of using the percentage of total sales, this method looks at the historical percentage of accounts receivable (AR) that went uncollected. 

Formula:

Percentage of receivables = (Estimated unpaid outstanding receivables x Receivables balance) / 100

Aging schedule method

The aging schedule method is a more detailed version of the percentage of receivables method, providing even more precision. 

An aging schedule categorizes invoices based on how overdue they are—such as current, 31-60 days past due, 61-90 days past due, and over 90 days. 

Each category is assigned a different uncollectibility percentage, with older invoices having a higher percentage since they’re less likely to be collected. The formula is applied separately to each category, and the results are added together:

Aging schedule = Percentage of outstanding receivables estimated uncollectible×Receivables balance (for each AR aging category)

Here's an example of a typical aging schedule:

‍Recording bad debt expense with the allowance method

Now, the above business has a history of bad debts and decided to create an allowance for bad debts account, setting aside $11,500 at the end of the month. To do this, they make the following entry:

This allowance for bad debts is a contra-asset account, meaning it reduces the total value of your assets on the balance sheet.

Writing off a specific amount using the allowance method

A few weeks later, suppose a customer informs you they can’t pay the $11,500 they owe.

Since the business already set aside a reserve for such losses, they record the following entry:

This process ensures books accurately reflect expected losses without affecting the income statement at the time of the actual write-off.

How to manage and minimize bad debt expense?

While you can’t control whether your customers will always be able to pay—though credit checks can help—you can take proactive steps to keep your collections process running smoothly.

1. Explore outsourced solutions

Outsourcing your receivables management to part-time accounting professionals can bring specialized expertise to your business, improving the efficiency of collections and reducing bad debt. 

These experts have the experience and tools to handle the collections process effectively, freeing up your time to focus on your core business activities.

2. Consider accounts receivables financing

Receivables financing are options that allow businesses to manage cashflow and minimize bad debt by selling unpaid invoices to a third party at a discount. 

While these solutions offer quick cashflow relief, it's important to understand the costs and risks involved. 

Bringing in fractional expertise can help you navigate these options and make well-informed decisions.

3. Automate processes to prevent delays

Automating your invoicing and collections processes can reduce errors and ensure faster payment collections. 

Tools like automated invoicing systems, payment reminders, and electronic documentation can help you stay on top of your receivables and avoid the delays that can lead to bad debt. 

4. Set up upfront credit and collection policies

Consider requiring a deposit upfront or offering discounts for early payments. Whatever strategy you choose, it's crucial to make your payment terms clear to your customers from the start. 

This helps set expectations and encourages timely payments.

Secure your business from unexpected bad debts with credit insurance. 

Protecting your business from bad debt

Bad debt is an inevitable challenge for any business that extends credit, but it doesn’t have to undermine your financial health. 

By understanding what bad debt expense is, calculating it accurately, and implementing strategies to manage it, you can safeguard your cashflow and maintain the stability of your business. 

However, even with the best practices in place, unexpected financial hurdles can still arise. That’s where solutions like invoice financing come into play. By partnering with Stenn, you can convert your outstanding invoices into immediate cash within 24 hours.

So, don’t let bad debts hold you back—explore invoice financing today and keep your cash flow moving smoothly.