For companies that provide credit sales, accounts receivable balances will always exist. These balances are a part of a company’s balance sheet. They represent the total amount owed from customers who have not repaid their dues. However, it may also include some balances that companies do not expect to recover. Therefore, bad debts will also be inevitable for those companies.

What are Bad Debt Expenses?

Bad debt expenses represent the total account receivable balances that companies deem irrecoverable. Through these expenses, companies account for receivable accounts that they expect not to be repaid. Bad debts can arise when a customer cannot pay or choose not to do so. Usually, the decision to treat a balance as bad debt depends on how they perceive the customer.

Sometimes, customers may not directly imply no repayment. However, if a company deems the expectancy for recovery below, it may treat it as a bad debt. The requirement to do so comes from the prudence concept in the account. This concept states that companies must not overstate their assets and understate their liabilities. The prudence concept also gives rise to the need to recognize provisions.

Bad debt expenses represent irrecoverable debts. Usually, these result in a reduction in the accounts receivable balances in the financial statements. It is an expense as it results in a loss of cash income for a business. On top of that, it also reduces the resources that the company owns. Therefore, companies write off those balances.

What is Allowance for Receivables?

Sometimes, companies may not deem receivable balances as irrecoverable. However, there may be some concern regarding the recoverability of those balances. Based on past experience, companies may decide to write off some balances. This process also relates to the prudence concept. However, allowance for receivables only increases expenses. These allowances do not affect receivable balances.

Allowance for receivables ends up in a specific account. This account acts similar to depreciation. Companies must net off their account receivable balances with the allowance for receivables balances. However, the receivable account itself does not get affected. Instead, it stays in a separate account and only reduces the accounts receivable balance if the bad debt materializes.

Related article  Top Five Accounting Books for GAAP and IFRS (2021)

Overall, allowance for receivables is a part of the bad debt process. Companies must calculate these allowances based on previous experiences. When an allowance becomes a bad debt, companies must reduce the accounts receivable balance. Instead, if a company recovers those balances, it must overturn the balance in the allowance account.

How to calculate Bad Debt Expenses (Step by Step Guide)?

There are two methods that companies can use to calculate bad debt expenses. Under both of these methods, the results may differ. However, companies can get an estimate of their overall bad debts. These two methods include the direct method and the allowance method. A step-by-step guide on how to calculate these is as below.

Direct Method

The direct method of calculating bad debts is straightforward. Companies must make a list of their customers that owe them balances. Based on the list, companies must estimate whether they deem a specific receivable balance as irrecoverable. There are several tools that may help in this process. One of these includes the aging receivables analysis that provides a timeframe for how long receivable balances have existed.

The direct bad debt expense method requires companies to eliminate all irrecoverable balances. There is no specific guidance on how to separate these balances. On top of that, the recoverability may differ from one industry to another. Regardless of that, companies must establish some rules to make the decision process straightforward.

Once companies identify irrecoverable balances, they must recover a bad debt expense. This expense will increase a company’s total expenses in the income statement. On the other hand, it will also reduce the accounts receivables balances in the balance sheet. Companies can use the following journal entries to record bad debts under the direct method.

Related article  Is Owner Withdrawal a Debit or Credit? (Accounting for Owner Withdrawal)
DateDescriptionDrCr
 Bad debt expensexxxx 
 Account receivable (specific customer) xxxx

Once they record the bad debt expense, the account receivable balance will change. This new balance will be known as the adjusted accounts receivable balance.

Allowance Method

The other method for recording bad debts is the allowance method, also known as the estimation method. Within this method, companies have two ways of estimating allowance for receivables. As mentioned, these are not actually bad debts. However, companies can use historical information to make an allowance for doubtful debts.

Regardless of the method used within this process, the journal entries will be the same. Companies can use the following entries to account for the allowance for receivables.

DateDescriptionDrCr
 Bad debt expensexxxx 
 Allowance for receivables xxxx

The two methods for calculating the allowance for doubtful debts are as follows.

Percentage of sales method

The percentage of sales method requires companies to estimate allowances based on their sales. As mentioned, companies can use historical information to calculate a specific rate. Usually, companies calculate bad debts as a percentage of sales for past periods. Based on that, they estimate the allowance for receivables under this method.

The formula for the percentage of sales method is as follows.

Allowance for receivables = Sales for the accounting period x Estimated percentage of bad debts

Based on this formula, companies can calculate the total expected bad debts. However, as these are not actually irrecoverable, they will be a part of the allowance for receivables account.

Percentage of debtors method

The percentage of debtors method is similar to the percentage of sales method. However, instead of using a company’s sales to estimate allowance, it uses accounts receivable balances. This method requires the adjusted accounts receivable balances after recording bad debts. Like the other method, this method also requires companies to use historical information to estimate a percentage.

Related article  3 Main Purposes of Financial Statements (Explained)

The formula for the percentage of debtors method is as follows.

Allowance for receivables = Adjusted accounts receivable balance x Estimated percentage of bad debts

Companies can also select specific segments from the adjusted accounts receivable balance. For example, a company may only take 1% of debtors whose age is below 30 days. In contrast, the percentage for those above 30 days maybe 3%.

Example

A company, ABC Co., has an accounts receivable balance of $500,000. However, the company expects some of the balances within this amount to be irrecoverable. Furthermore, ABC Co. uses the percentage of debtors method to create an allowance for receivables. The company has studied its historical bad debts and estimates the allowance percentage to be 6%.

Firstly, ABC Co. identifies a list of customers that it deems as unable or unwilling to repay their debts. The aggregate balance for these customers is $50,000. Therefore, ABC Co. must record the bad debts as follows.

DateDescriptionDrCr
 Bad debt expense $  50,000 
 Accounts receivable     $  50,000

After recording the bad debt expense, the adjusted accounts receivable balance will be $450,000 ($500,000 – $50,000). Based on this balance, ABC Co. can calculate the allowance for receivables. The company must first calculate the allowance using the formula and estimated percentage. The calculation is as follows.

Allowance for receivables = Adjusted accounts receivable balance x Estimated percentage of bad debts

Allowance for receivables = $450,000 x 6%

Allowance for receivables = $27,000

Therefore, ABC Co. must record this amount in its accounts. The journal entries will be as follows.

DateDescriptionDrCr
 Bad debt expense $  27,000 
 Allowance for receivables  $  27,000

Based on the above information, the accounts receivable balance reported in ABC Co.’s financial statements will be below.

DescriptionAmount
Accounts receivable balance $        450,000
Less: Allowance for receivables $        (27,000)
= Reported accounts receivable balance $        423,000

Conclusion

Bad debts are accounts receivables balances that companies deem to be irrecoverable. Allowance for bad debts is an estimation of how much bad debts may occur based on historical information. Companies can calculate bad debt expenses by using the direct method followed by the allowance method. Based on these, companies can reach a reportable accounts receivable balance.