How To Calculate Bad Debt Expense: A Guide

In a perfect world, every customer pays their bills in full and on time.

However, as most small business owners know, that’s a far cry from reality. Customers will often delay their payments or avoid paying altogether for goods or services they purchased from you.

In addition to the financial strain this places on your business, these unpaid “sales” must now be properly accounted for, especially if you use accrual accounting and have already counted the sale as income. This guide will show you how to calculate bad debt expenses so you can handle these situations like a pro.

What Are Bad Debt Expenses?

Bad debt expenses represent the money a business doesn't expect to collect from customers who bought products or services on credit.

Picture this: You sell your product or service, but instead of getting paid right away, you're left waiting. After a while, you realize that the payment might never come. That's what you have to chalk it up as a bad debt — it's the cash you counted on but won't be seeing.

These situations typically happen when customers run into financial trouble and can't pay their bills. Businesses must account for these losses to make sure their financial statements accurately represent their financial situation, helping them make better decisions based on realistic income and receivable numbers.

The Importance Of Accounting For Bad Debt

Accounting for bad debt isn't just about knowing who hasn't paid up; it's about smart business.

When you keep your books fresh with the latest receivables, you're setting yourself up to make sharper financial choices and even give your taxes a little nudge in your favor. Here are some reasons why this part of accounting is so important:

Ensure Financial Accuracy

By keeping tabs on unpaid debts and late payments, businesses can paint a true-to-life portrait of their financial statements and the value of their receivables. It's all about factoring in those uncollectible accounts when creating a balance sheet and weighing the cost of debt.

Assess Credit Risk

It's a reality of doing business: Some customers are more reliable than others. Knowing the likelihood of bad debts can help a business adjust its credit policies, potentially tightening credit terms on certain customers or enhancing credit evaluations.

Tax Reporting

Recognizing these expenses can help businesses create bad debt write-offs. When properly accounted for, businesses can write off bad debt and reduce their tax liabilities, boosting their adjusted gross income.

Strategic Planning

Understanding why your customers are unable to meet their financial obligations can help you improve your customer management and risk mitigation strategies. You'll be in a better position to tweak your payment terms or credit rules to ride the wave of market changes.

Types Of Bad Debt

Bad debt comes in two forms, reflecting different stages in how businesses recognize losses from customers not paying their bills. Actual bad debts reflect those that a business knows it won’t be able to collect on, while a provision for doubtful debts reflects a hunch that some bills will be unrecoverable. Here's a closer look:

Actual Bad Debts

Actual bad debts happen when a business decides it definitely won't be getting paid by a customer. This decision comes after trying hard to collect the money and finding out the customer just can't pay, maybe because they've gone bankrupt.

When this happens, the business writes this amount off as a loss right away, affecting its income statement. This also adjusts the balance of money expected to come in, shown on the balance sheet, to only include what's truly expected to be paid.

For example, if a company tries for months to collect $1,000 and then learns the client filed for bankruptcy, then that $1,000 gets removed from the receivable balance and marked off as a loss through a debit expense within the accounting period.

Provision For Doubtful Debts

On the other hand, the provision for doubtful debts is like setting money aside for accounts receivable that might turn into losses later. This becomes a sales entry, increasing the credit balance before the bad debts reduce it.

This step is taken before knowing for sure which specific accounts won't pay. It's based on experiences and the general economic outlook.

For example, if a company usually sees a 2% loss from not getting paid on credit sales, it might set aside 2% of its total credit sales in a bad debt reserve as a safety net for these potential losses. This allowance for doubtful accounts appears on the balance sheet as a reduction in the total value of expected income, ensuring the company doesn't look financially stronger than it actually is, incorporating the bad debt expense formula into its financial planning.

How To Calculate Bad Debt Expense

Getting a handle on bad debt expenses lets businesses brace for the impact of customer payments that might never land. The two most common methods are the percentage of sales and aging of accounts receivable methods. Here’s how to calculate them:

1. Percentage Of Sales Method

This method estimates bad debts based on a set percentage of total credit sales, using historical data to predict future uncollectible amounts.

Formula: Bad Debt Expense = Total Credit Sales × Estimated Bad Debt Percentage

Example: If a company's credit sales are $200,000 and it estimates 2% will be uncollectible based on past trends, the bad debt expense is $200,000 × 2% = $4,000.

2. Aging Of Accounts Receivable Method

This method examines the age of each receivable to estimate bad debts, assuming older accounts are less likely to be paid. This method takes into account that a receivable that is just a few days late is much more likely to get paid than one that is several months late.

To calculate this:

1. Sort all receivables by how long they've been outstanding (e.g., 0-30 days, 31-60 days).
2. Apply a higher uncollectible rate to older receivables based on past experience.
3. Calculate the estimated bad debt for each age group and add them up for the total.

Formula for each age group: Estimated Bad Debt = Amount in Each Category × Estimated Uncollectible Rate

Example: Company A has receivables of $40,000 (0 to 30 days), $10,000 (31 to 60 days), and $5,000 (over 60 days) and assigns them rates of 1%, 5%, and 10%, respectively. The calculation is:

$40,000 × 1% = $400

$10,000 × 5% = $500

$5,000 × 10% = $500

The total provision for doubtful debts would be $400 + $500 + $500 = $1,400. This creates administrative costs and journal entries that accurately reflect these anticipated losses.

Real-World Examples Of Bad Debt Expense Calculation

Microsoft tackles its bad debt expenses by making educated guesses on which receivables might go sour. Here's a simplified look at its method using information from its Securities and Exchange Commission Form 10-K from the fiscal year ending on June 30, 2021:

1. Microsoft starts by identifying financially troubled accounts that are having issues with paying and making a journal entry for write-off when necessary.
2. Microsoft then reviews its history of unpaid accounts to estimate how much of its current sales might not be collected.
3. Microsoft also considers the present economic environment and any changes in how creditworthy its customers are to maintain an accurate bad debt expense account.

In its financial updates, Microsoft shows how the allowance for doubtful accounts changes over time. It lists the starting balance, adds any new amounts set aside for potential bad debts, subtracts debts they've decided won't be paid, and then shows the final amount.

For instance, in 2021, Microsoft reported an initial balance of $816 million for potential bad debts. It then added $234 million to this pool based on recent evaluations. It then removed $252 million, as these were debts it no longer expected to collect. This left Microsoft with an ending balance of $798 million in their allowance for doubtful accounts.

Best Practices For Managing Bad Debt Expenses In Your Business

Keeping bad debt expenses manageable is key to your business's overall financial wellness. Implementing effective bad debt management strategies can significantly mitigate the impact of unpaid invoices:

Set Strict Credit Policies

Setting strict credit standards is key. Dive deep into a customer's credit background before you decide to extend credit. Spell out credit caps and payment conditions upfront. This tightens the reins on risk and clears the air, avoiding potential mix-ups.

Set Clear Terms Of Payment

Communicate payment terms upfront, including specific due dates and the consequences of late payments. Early payment incentives could help you increase your collection rate.

Invoice Quickly And Follow Up

Invoice immediately after a sale and diligently follow up on overdue payments. Early reminders and consistent communication can significantly increase your chances of collecting owed money.

Set Money Aside

Estimate the potential for uncollectible accounts based on historical data and current economic conditions. This proactive approach helps cushion your finances against the impact of bad debts.

Watch Receivables Closely

Monitor your accounts receivable aging report to quickly identify and act on overdue payments. Spotting trouble early with frequent check-ins means you can step in swiftly — maybe with a payment nudge or a chat about terms — to cut down on possible losses.

Embrace Technology

Utilize advanced accounting software for streamlined invoicing, automatic reminders, and real-time accounts receivable insights. Switching to automated systems can be a game-changer, saving you time, eliminating mistakes, and offering up data that's gold for making smart choices.

Proactively Manage Your Financial Health

In business, not all sales lead to payments. Customers sometimes delay or skip payments entirely, and it's vital to account for these losses accurately. This guide covered how to calculate bad debt expenses, preparing you to deal with such challenges effectively without having to rush into debt financing to survive.

To take even further control of your business’s finances, speak with a financial professional to discuss how to plan for bad debt expenses.

‍