Companies use various techniques to increase their revenues. One of the most reliable ways to achieve it includes offering credit purchases. Usually, companies prefer to receive cash for their sales. This process reduces the time for companies to complete their operational cycle. However, some customers may not have money readily available. These customers may request goods in exchange for credit.
Credit sales allow companies to sell goods or services for future promised payments. This process involves delivering the item without a cash payment. Instead, the company sends an invoice to the customer requesting a settlement. In the meanwhile, the company records a receivable balance in its books. Once it receives the sum from the customer, the company removes that balance.
In some cases, however, companies may not recover the amount owed by customers. It may occur for various reasons. Nonetheless, accounting standards may require companies to record a bad debt expense instead. However, it does not guide companies on whether it should be a part of operating expense or the cost of sales. Before that, it is crucial to discuss what bad debt expense is.
What is a Bad Debt Expense?
When a company provides goods or services for credit, it allows the customer some time to pay. This time comes from the agreement between both parties. Usually, every company establishes its credit terms based on various factors. In most cases, customers reimburse the company within that time. Sometimes, however, they may fail to do so. Consequently, companies must determine whether those balances have become bad debts.
Bad debt is an expense recognized by companies for receivable balances. It represents money owed by customers to a company that it does not deem recoverable. In other words, a bad debt expense is a charge for an irrecoverable receivable balance. Usually, companies record it when a customer fails to repay their owed amounts in time. However, companies must ensure that the balance is uncollectible before charging a bad debt.
A bad debt expense is essential for companies to remove irrecoverable balances from their books. In accounting, doing so is crucial to presenting an accurate picture. This charge increases the expenses in the income statement. At the same time, it decreases the accounts receivable balance on the balance sheet. Companies record bad debt expenses regularly. For companies offering credit sales, bad debts are an inevitable part of the business.
Customers may default on their payments for several reasons. The most prevalent of these include the customer going into bankruptcy or liquidation. Similarly, financial issues at the client can also cause them to fail to reimburse their suppliers. When these issues persist, companies must determine whether the debts are irrecoverable. If that is the case, they must recognize a bad debt expense.
What is the Accounting for Bad Debt Expense?
The accounting for bad debt expense is straightforward. However, it encompasses a process that goes behind the scenes. This process begins when a company does not expect customers to pay their owed amounts. These amounts relate to the sale of goods or services in the past. As stated above, companies send invoices for each item sold to a customer. Their owed amount reflects the sum of those invoices.
When a company deems a balance irrecoverable, it must record a bad debt expense. Usually, companies use historical information to determine if a debt has gone bad. In some cases, it may also be apparent. For example, if a customer goes under liquidation, the recoverability of their owed amount becomes nil. Once companies determine a balance to be uncollectible, they must record a bad debt expense.
The accounting for bad debt expense is straightforward. It involves recording an expense while reducing the accounts receivable. Therefore, it impacts the income statement and the balance sheet simultaneously. Once recognized, this amount does not appear on the balance sheet as a recoverable balance. Similarly, it reduces profits or increases losses for that period.
Usually, the accounting for bad debt expense ends with that process. In some cases, companies may recover balances even though they were irrecoverable before. If that occurs, companies must reverse the accounting for bad debt expense. Usually, this process involves creating an income on the income statement. On the other hand, it increases the cash and cash equivalent balances.
Is Bad Debt an expense?
Most users wonder if bad debt is an expense since it reduces account receivable balances. The answer to that question isn’t as straightforward. As mentioned above, bad debts involve two sides when accounting for these amounts. The first requires creating an expense that reduces profits or increases losses. The other is decreasing accounts receivable in the balance sheet.
It is also crucial to understand the definition of the term expense in accounting. This definition can help set apart bad debts from other items in the financial statements. Essentially, accounting defines expenses as outflows of economic benefits during a period. These outflows also relate to the revenues they help generate. Bad debt expense meets this definition.
Therefore, bad debt is an expense. However, it also reduces the accounts receivable reported in the balance sheet. It appears on the income statement separately. Usually, it is a part of a general heading while it falls under the notes to the financial statements. On the other hand, it does not appear on the balance sheet. Bad debt only increases accounts receivable that are a part of this statement.
Is Bad Debt a Contra Asset Account?
Some users also wonder if bad debt is a contra asset account. Before discussing that, it is better to define what this account is. Essentially, a contra asset account is an account in the books that includes a negative asset balance. This account does not appear on the balance sheet. However, it reduces the value of a specific account reported in the financial statements.
Most people confuse bad debts for a contra asset account because of allowances for doubtful debts. The latter is an account that includes receivable balances that may be irrecoverable. Usually, companies record these based on their past experiences with customers. However, these do not constitute an actual reduction in accounts receivables.
On the other hand, bad debt decreases account receivable directly. It does not involve creating a separate account which reduces those balances indirectly. Therefore, bad debts are not a contra asset account. They do not have an account for balances at all. Instead, bad debts cause a reduction in the account receivable balances in the balance sheet.
Is Bad Debt Expense part of Operating Expenses or Cost of Goods Sold?
Bad debt expenses related to the goods or services delivered to a customer. Since the initial items fall under the cost of goods sold, most people think it must include bad debts. While that is reasonable, it is crucial to understand how a receivable balance becomes irrecoverable. On top of that, users must understand what expense classify as the cost of goods sold.
Cost of goods sold includes expenses directly related to a company’s core activities. Usually, it consists of the cost of producing a product or service. On top of that, it only considers direct expenses rather than indirect. Bad debt expense does not meet any of those definitions. Therefore, companies cannot put this expense under the cost of goods sold.
Instead, a bad debt expense is an operating expense. Companies classify it as underselling and administrative expenses. Usually, bad debts stem from a company’s inefficiency to recover owed amounts from customers. These are indirect expenses that do not relate to its core activities. Therefore, companies classify bad debt expenses as operating expenses in the income statement.
Conclusion
Bad debt expense relates to balances that companies deem irrecoverable. These balances come from customers to whom a company has delivered goods or services. Essentially, bad debt expenses reduce profits while decreasing account receivable balances. Companies classify them as operating expenses since they do not relate to their core activities.