BlackLine Blog

July 08, 2024

What To Do When Customers Won’t Pay: Managing and Recording Bad Debt

Consolidation & Financial Analytics
5 Minute Read
PJ

PJ Johnson

Share Article

In today’s business economy, encountering unpaid invoices and uncollectible accounts is inevitable. Understanding how to manage and record bad debt effectively is essential for maintaining financial health and stability.

And this starts with understanding what bad debt is.

What is Bad Debt?

In finance and accounting, bad debt refers to accounts receivable that customers have deemed uncollectible and, therefore, written off as losses.

This occurs when customers are unwilling or unable to pay off their outstanding debt despite a business's efforts to collect it.

Most businesses will extend credit to their customers at some point in their lifetime because it helps them build trust with customers and expands the pool of potential customers by offering more payment options.

In addition, some customers cannot or do not prefer to pay with cash.

The downside of credit is that some customers will not be able to pay off their outstanding debt, and the business will have to write off the debt as a bad debt expense on their income statement, reducing the net income for the period.

What is a Bad Debt Expense, and How to Record It?

Bad debt expense is an accounting term for how bad debt is recorded in the business ledger.

Businesses must record bad debt to properly account for the expectation that they may never receive full payment. The bad debt expense is posted to the income statement as an operating expense and will offset accounts receivable on the balance sheet.

Recognizing bad debt expenses is essential for businesses to accurately record their revenue and the costs that detract from it.

How to Calculate Bad Debt

Bad debt expenses can be calculated in one of two ways:

  1. Direct Write-Off Method: According to the direct write-off method, a bad debt expense is recorded as a debit in the Bad Debt Expense account and as a credit in accounts receivable (AR). 

This follows the double-entry accounting system, in which every transaction recorded in an accounting ledger impacts at least two accounts. In this system, journal entries will always have a debit and a credit in the ledgers where they are recorded, and they will always balance out.

In business accounting, AR is considered an asset.  In the direct write-off method, an entry for bad debt will add to the total expenses incurred by the business while reducing the value of AR because it is an asset that the company does not expect to collect.

Businesses use the direct write-off method for income tax purposes, and the IRS allows it because it is a more accurate way of calculating bad debt.

On the other hand, the method does not comply with the generally accepted accounting principles (GAAP) because it does not meet the so-called matching principle.  This principle requires that expenses are matched or recorded with corresponding revenue in the same accounting period when both occur.

2. Allowance Method: A second method of calculating bad debt expense considers this. When using the allowance method, a business estimates how much of its accounts receivable will be recorded as bad debt. This is more complicated and less accurate than the direct write-off method, but it enables a business to match bad debt to revenues during the same accounting period.

Using this method, the estimate for bad debt expenses is referred to as an allowance for doubtful accounts, and it is recorded in a contra-asset account. The purpose of the contra-asset account is just as the name suggests. Its value is contrary or contrasting to that of a regular asset account.

While assets like accounts receivable have a positive value and increase as debits are recorded, a contra-asset account has a negative value and increases as credit is recorded. In this way, a contra-asset account offsets or nets the value of the asset account. The allowance in the contra-asset account for a bad debt expense offsets or nets the corresponding accounts receivable asset when compiling the balance sheet.

Eventually, the business will write off the bad debt.  When this occurs, the bad debt will be recorded as a debit to the contra account and as a credit to the accounts receivable.  The bad debt has gone from an estimate to an actual number, the allowance is no longer needed, and the ledgers will reflect this change.

How Businesses Estimate Bad Debt Expense

Businesses estimate bad debt expenses when they are using the allowance method by employing one of two methods:

Percentage Sales Method: The percentage sales method involves two steps.

In the first step, accountants determine a historical rate or percentage of bad debt by dividing the business's total or average amount of bad debt over time by the total or average amount of credit sales or AR over the same historical period.

Once they determine this percentage, accountants perform the second step by multiplying that percentage rate by the current total amount of credit sales or AR.  This calculation will estimate bad debt expenses for the current credit sales or AR amount.

For example, if a company has averaged credit sales of $100,000 over the past five years and a bad debt expense of $20,000 over the same period, it would calculate the bad debt expense rate as follows:

Step 1.  $20,000 ÷ $100,000 = .2 (20 %) bad debt expense rate

The company's credit sales have increased slightly to $120,000 in the current year.  To calculate an estimate for bad debt expenses in the current year, accountants would apply the rate they calculated in step 1 to the current year's credit sales:

Step 2.  .2 X $120,000 = $24,000

In this example, the company's contra-asset account would record an estimated $24,000 in bad debt expenses.

Accounts Receivable Aging Method: This method relies on an aging report that classifies AR invoices based on their age. 

Invoices are broken down by periods of overdue time, ranging from 0 to 30 days, 31 to 60 days, 61 to 90 days, and so on.

This method calculates bad debt expense estimates by applying a different rate to each aging category. 

Older debts are less likely to be collected, so a higher ratio is applied to the figures in these categories.

The rate applied to each aging category is based on a combination of company and industry averages. For example, invoices in the 0 to 30-day category may be assigned a bad debt expense rate of .01 or 1 percent, and invoices in the 31 to 60-day category might be assigned a rate of .4 or 4 percent.

If the aging report for a business shows AR balances of $30,000 in the 0 to 30-days category and $15,000 in the 31 to 60-day category, it would calculate its bad debt expense allowance by applying the respective rates to the total amount in each category and adding them together:

[$30,000 X .01 = $300] + [$15,000 X .04 = $600] = $900

In this example, of the total AR balance of $45,000 ($30,000 + $15,000), the company will record a bad debt allowance of $900 in its contra-assets account.

This is a blended method that arrives at a mid-range estimate between the result of multiplying the entire AR amount by the lower rate of 1 percent (.01 X $45,000 = $450) and the result of multiplying the total by the higher rate of 4 percent ($45,000 X .04 = $1800).

What Companies Should Do When Bad Debt Occurs

Like taxes and inflation, bad debt is inevitable, especially if businesses offer credit options to customers. Any company that extends credit to its customers, which most do, will have accounts receivable, and with AR comes some unpaid debt.

A business can best prepare to reap the benefits of credit by having a credit management system to minimize risk and a collections management system to guide the collection of overdue payments.

Even with all these systems in place, bad debt will occur. A business can prepare for the inevitable by having the appropriate accounting procedures in place to record and calculate these unpaid transactions properly.

Properly accounting for bad debt expenses ensures more accurate revenue and expense reporting. This minimizes surprises and unexpected spikes and dips in revenue figures. For this reason, bad debt should always be reported in a timely fashion and with the utmost accuracy that the methods allow. Investors, lenders, and regulators expect this when examining a business's financial statements.

How BlackLine Revolutionizes Your Invoice to Cash Accounting Process

Relying on time-consuming and tedious manual entry of unpaid invoices can slow payment collection and compound the problems associated with bad debt.

BlackLine Cash Application revolutionizes the invoice-to-cash cycle by significantly reducing the time needed to apply payments.  Leverage AR automation to eliminate manual accounts receivable processes, gain visibility and control, and achieve your organization's most efficient end-to-end invoice-to-cash processes.

About the Author

PJ

PJ Johnson