How To Record a Bad Debt Expense: Everything You Need to Know

Introduction

When you sell goods or services to customers on credit, there is always a risk of non-payment from customers with receivables aging and becoming uncollectible. 

Such debts that a business estimates will not be collected from customers are considered bad debt expenses. Businesses must understand bad debt expenses and record them in the books without any errors. This amount is written as a reduction against net income because despite you booking the revenue, the sales never got translated into cash. 

Want to understand how bad debt expense is treated in the financial statements? This blog covers everything you need to know about bad debt expense journal entries. Let’s dive in. 

Before we dive into entailing bad debt expense journal entry, let’s first understand what a bad debt expense is.

What Is a Bad Debt Expense Journal Entry?

When a business makes a credit sale, it credits the revenue and debits AR. However, the risk of receivables becoming uncollectible will always exist. A business has to estimate and record this uncollectible as a reduction against net income. This estimated amount is known as a bad debt expense. 

Bad debt expenses are generally considered part of sales or general administrative expenses. Also, this bad debt needs to be written off in the financial records.

In the bad debt expense journal entry, you debit the bad debt expense account and credit the allowance for uncollectible amounts. While a portion of bad debt expense is kept in the balance sheet, the full amount of the expense is posted in the income statement to offset the reduction to AR. 

The allowance for doubtful accounts is a contra-asset account used to record the estimated amount of uncollectible receivables. It’s important to note that businesses retain the right to collect funds if circumstances change, even after the expense has been written off.

Where is bad debt expense recorded? 

Bad debt expense is recorded within the general, selling, and administrative expense heads of the income statement. However, the entries to record bad debt expenses are spread throughout the financial statements. You will find out the allowance for doubtful accounts on the balance sheet as a contra asset. On the other hand, any bad debts that have been directly written off will reduce the AR balance on the balance sheet. 

What are the reasons behind bad debt expense accounts? 

Bad debts usually occur due to: 

• When customers are not satisfied with your goods or services and refuse to pay. 
• Customers are financially in a tight spot or on the verge of bankruptcy. 
• Sales teams are not efficient enough to offer better credit terms or frame negotiations without the AR team’s input, creating confusion around payment terms. 

Apart from this, one of the major reasons behind bad debt expense is if you have a higher day sales outstanding (DSO). It refers to the average number of days it takes for a business to collect payment after a sale has been made. A higher DSO means longer collection times andslow processing. This extended collection period increases the chances of receivables becoming uncollectible, leading to higher bad debt expenses. The longer the receivables are outstanding, the greater the risk that customers will default. 

Therefore, businesses with higher DSO must closely monitor their accounts receivables and proactively improve their collections by tightening their credit policies or enhancing dunning processes. Effective DSO management and employing debt collection strategies are critical to reducing the risk of bad debt and lowering the bad debt expense.

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Understanding the Significance of Bad Debt Expense

Bad debt expense is an integral part of the collection process that helps reflect and mitigate credit risk, inform and prioritize collection strategies, improve financial planning, enhance customer segmentation, identify default accounts, and allocate resources.Accurately recording and analyzing bad debt expenses enables you to manage your accounts receivable and reduce your potential losses effectively.

Here are more reasons why considering bad debt expenses in the financial books is vital. 

• Reflect credit risk Understanding bad debt expense helps you assess the effectiveness of your credit policies and identify areas where credit risk is high. This will assist you in making prompt adjustments in credit terms and implementing more stringent credit checks to mitigate credit risk. 
• Inform collection strategies Recording bad debt expenses helps analyze historical data, allowing you to rethink and refine your collection strategies. If bad debt expenses are higher than what you had expected, it means you need more aggressive collection efforts or changes in the customer credit evaluation process. 
• Faster identification of default accounts Managing bad debt expenses will help you identify customer accounts that may fail to pay before the invoice due date and take proactive actions. With these insights, you can dive into the underlying causes of default and devise strategies to mitigate non-payments and reduce their impact on the financial statements. 
• Prioritize collection efforts Knowing the amount of bad debt expenses can help you rethink and fast-track your collection efforts. For instance, if you find certain customer accounts as high-risk or historically problematic, your collections team can focus their efforts on these accounts to prevent further loss, ensuring that most critical accounts are addressed promptly to improve recovery rates. 
• Improves financial health Recording bad debt expenses on financial statements helps you lower the accounts receivables and show accurate income. It reflects positive financial health and enables you to pave the way for effective and accurate financial forecasting and planning. You can use this information to predict future cash flows and adjust your financial strategies to manage working capital and keep the business financially stable despite collection challenges. 

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Methods of Recording Bad Debt Expense

There are two methods to record a bad debt expense: 

• Direct write-off method
• Allowance method 

• Direct write-off method The direct write-off method allows you to write-off bad debt only when a specific account is anticipated to have become uncollectible. You will write off a part of the receivables as bad debt and post a bad debt journal entry by debiting the bad debt expense and crediting the accounts receivables.Here, bad debt expense is treated as a direct loss from the uncollectible that goes straight against revenues, reducing the net income. In one accounting period, you may experience a heavy rise in your receivables account. Then, in the next accounting period, you may find many customers defaulting on their payments, thereby lowering your net income. However, before writing off a debt, ensure you follow these IRS guidelines:
  • You must have strong evidence to prove that your customer will default. 
  • You must show that you have already taken reasonable measures to collect the outstanding debt, like contacting the customer or solving disputes. 
• Allowance method The allowance method is the best way to record bad debt expenses if you are dealing with large material amounts. The reason is using the contra asset account that goes against account receivables. A contra-asset account refers to an account with an opposite balance to the account receivable. While this method may look more complex on paper, it gives a more accurate assessment of your ability to collect receivables. GAAP recommends businesses use methods that comply with the matching principle. Here are the vital elements of the allowance method: 
  • Determine uncollectible invoices. 
  • In the journal entry, debit the bad debt expense and credit allowance for doubtful debt accounts. 
  • When writing off an account, debit allowance for doubtful accounts and credit the receivable account. 

  DateAccount titleDebitCredit 31 July 2024Bad debt expense a/c$500To allowance for doubtful accounts $500(To record estimate of uncollectibles)02 Aug 2024Allowance for doubtful accounts$500To Accounts receivables – Hersheys$500(To write off Hersheys’ account)Additionally, there are always chances that a customer pays the amount at a later date. This means you have to reverse the write off previously made and record the amount collected for receivables. DateAccount titleDebitCredit31 Aug 2024Accounts receivable – Hersheys a/c$500To allowance for doubtful accounts$500(To reverse write-off on Hershey’s accountCash a/c$500To accounts receivables – Hersheys a/c$500(To record A/R collection from Hersheys)

Example of Bad Debt Expense Journal Entry 

Let’s take an example of a retail company, ABC Ltd., that uses an allowance method to record bad debt expenses. Lately, its collection team found out that a local boutique shop, X&Co., is going through some financial downturn and may default in paying the last invoices. Here are the numbers: 

To record the bad debt expense in the financial books, it will first determine the amount of account receivables that will be uncollectible. This could be using: 

Percentage of sales 

In this method, you have to find out the percentage of net credit sales or total sales that you estimate is uncollectible. It is usually estimated by studying historical trends or anticipating credit policy. In this example, here’s what bad debt expense and accounts receivable in the books will look like. 

Now to reflect the estimated bad debts as an expense on the income statement, you will have to adjust the allowance account on the balance sheet. 

Percentage of receivables 

This is almost similar to the percentage of sales method, but uses account receivable instead of sales. The result you get will be the company’s ending balance for the allowance for doubtful accounts. Note that even if there are any overdue invoices from last year, they have been already included in the AR balances in the current year. 

Now, we have an opening balance of $1000 for the allowance for doubtful accounts that need to be adjusted with estimated amounts calculated. It will ensure that the amount aligns with the anticipated uncollectibles. 

The income statement will have this adjustment value when you record the bad debt expense. The journal entry for the same will look like this. 

The allowance method is known to give a more accurate presentation of a business’s financial position. When you record bad debt expense while writing off uncollectible accounts, it will help match the expense with the period in which the related revenue was recognized. 

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How Can Automated Collections Software Help Manage Bad Debt Expense?

Bad debt expenses arise from higher DSO and increasing receivables that become uncollectible. While automating the account receivables process may not directly reduce bad debt expenses, it will definitely help you streamline and optimize your collection process so you can effectively and accurately treat bad debt expenses and minimize the impact on financial performance. 

• Enhanced visibility with activity logging and trackingAutomated cloud solutions offer real-time visibility into outstanding invoices and overdue accounts with features for activity logging and tracking. It gives you a holistic view and chronological history of a customer’s complete collections activity, helping you analyze and detect the chances of an invoice becoming uncollectible early on. It is a single source of truth for all collection activities, with every activity logged and tracked. 
• Minimizing uncollectible invoices with collections workflows The AI-led customizable workflow uses AI algorithms that look at 20+ variables (Amount, Aging, Risk, and others) and 12 months of payment history to identify which customers should be contacted, suggest an action, and also assign it to a collector based on bandwidth. This not only helps you implement different collection strategies based on the risk level of accounts but also device measures to reduce bad debts and increase collections. It also automates reminders and follow-ups for overdue invoices, which helps improve the chances of collecting payments before they become uncollectible.
• Seamless integration with ERP and accounting systems Automated collections cloud seamlessly integrates into your ERP systems and accounting platforms to ensure that when a decision is made to write off a bad debt, the necessary journal entries can be made in the accounting system accurately and promptly. It will also keep your collections and accounting data synchronized to make sure that any write-offs or adjustments related to bad debts are reflected correctly in financial reports.
• Accuracy in reportingYou can automate the repetitive yet critical tasks in the collection process, like sending email reminders, transcribing customer interactions, solving disputes, etc. Typically, a collector spends 30% of their time sending emails. Automation will help them save time in accurately tracking the performance of collections efforts and identifying patterns or trends in bad debt when reporting in the financial statements. 

Boost Your Collection Efficiency with HighRadius Automated Collections Cloud 

Many collection analysts go for a reactive approach; they take action only after an invoice has hit past due status. Moreover, with time spent on manual login to AP portals to check the invoice status, analysts often miss out on critical updates on high-priority customers, failing to identify at-risk accounts. This not only leads to missed opportunities in recovering payments but also leads to inaccurate forecasting of bad debt expenses along with an increasing likelihood of receivables becoming bad debts. 

This is where HighRadius’ state-of-the-art collections cloud comes into play. Our automated collections solution uses historical data and customer payment behavior trends to come up with a payment prediction date for an invoice from the day the invoice is generated. The system then leverages this data to identify the customers who are most likely to go delinquent and prioritizes the analyst time accordingly. This will further help you identify at-risk accounts early and proactively take steps to prevent a receivable from becoming uncollectible. 

Additionally, we offer pre-built integrations with 1000+ portals through an AP portal automation feature that automatically pulls required data, logs it into the system, and gives deep insights into customer behaviors and trends. This means your analysts can screen high-priority accounts with the time they save, and with the insights, they troubleshoot non-payment issues to prevent bad debts.

FAQs

1) What are the three statements for bad debt expense?

It includes the income statement, balance sheet and journal entry. It is a part of the general, selling, and administrative expense in the income statement. In the balance sheet, it will be a contra asset with allowance for doubtful debt amount reduced from AR. For journal entry, you debit the bad debt and credit AR.

2) How is bad debt shown in the balance sheet?

Bad debt expense is written as the allowance for doubtful accounts on the balance sheet as a contra asset. Any bad debts that have been directly written off will reduce the balance of accounts receivables on the balance sheet. A contra-asset refers to an account with an opposite balance to AR.