What is Bad Debt Expense? What is an Example of a Bad Debt Expense?

What is Bad Debt Expense?

Bad debt expense refers to the amount of money a company expects to receive and lose due to customers failing to pay their debts.  

Accounting concepts reflect the financial trouble associated with expanding to clients when they cannot complete their payment commitments due to financial difficulty or insolvency, and the money they owe becomes a bad debt for the company.

These bad debts are documented as an expense on the company's income statement which might lessen the reported profit and provide a more accurate picture of the company's financial health, reducing its net income.

What is an Example of a Bad Debt Expense?

Let's explain this section to make you understand much better by demonstrating the bad debt expense in action. For Example, Suppose a product manufacturer expands the recognition to a construction company Building Solutions Inc., for raw materials needed for a big project.

However, due to financial challenges and unexpected delays met by Building Solutions Inc., they couldn't pay their outstanding invoices totaling $50,000. As an outcome, the prouct Manufacturing recognizes that the $50,000 owed by Building Solutions Inc. is doubtful to be collected or repaid.

Therefore, a product Manufacturing factory registers this amount as a bad debt expense in its financial records, reflecting the loss due to the uncollectible debt.

Method to Calculate Bad Debt Expenses

There are two preliminary methods to calculate bad debt expense, and they are the allowance method and the direct write-off method

Direct Write-Off Method

It involves instantly identifying uncollectible account payments when they become noticeable. While, it is specific and doesn't stick to any accounting principles, such as matching expenses to revenues.

Allowance Method

Companies estimate in advance possible bad debts and make an allowance for doubtful accounts. This allowance is removed from accounts receivable, meditating a more accurate presentation of predicted losses.

Bad Debt Expenses Estimation

Assessing bad debt expenses involves expecting the amount of accounts receivable that may not collected.

There are two estimation methods: Net Sales Percentage and Statistical Modeling.

• Statistical Modeling: This method is statistical calculations, such as default probability, based on documented data from the business industry. The bad debt percentage may expand with the years of the receivable to meditate and increase the risk of insolvency.
• Net Sales Percentage: Based on historical experience, the company's net sales Percentages estimate and bad debt expense by applying a percentage to their net sales. It provides a simplified bad debt expense estimation but may not capture all nuances of the creditworthiness of individual customers.

Utilizing these estimation methods accounts for potential bad debts maintaining correct financial records and risks associated with extending credit.