What it means
Selling on credit is normal in business, but not every customer pays. Some go bankrupt, some dispute the invoice, and some simply disappear.
Once a company concludes that a particular debt is unlikely to be recovered, it is bad debt. The accounting follows the principle that profit should not be overstated.
Under the allowance method, the company estimates in advance how much of its receivables (money customers owe) will not be collected and records an allowance for doubtful debts. This charge goes to the income statement as bad debt expense in the same period as the sale, so revenue and its related cost appear together.
When a specific invoice is confirmed as uncollectable, it is written off against the allowance, which removes the receivable from the balance sheet. The alternative direct write-off method records the expense only when the debt is declared bad.
It is simpler, but it can push the cost into a later period than the sale, so it is generally acceptable only for small amounts. Estimates often rely on an ageing analysis, which groups invoices by how overdue they are and applies a higher percentage loss to older balances.
Companies can also apply a percentage to total credit sales, based on past experience. Newer accounting standards ask businesses to consider expected losses from the start, taking account of economic conditions.
Bad debt can be reduced by checking a customer's creditworthiness before selling, setting credit limits, invoicing promptly, chasing overdue amounts, and using credit insurance. If a written-off debt is later recovered, it is recorded as income at that time.
Tax relief for bad debts is available in many places, but conditions vary and should be checked. The level of bad debt is also a signal about the whole business.
A rise might show that customers are in difficulty, that credit checks are too light, or that sales staff are pushing deals to risky buyers in order to hit targets. Boards often review bad debt as a percentage of credit sales, and compare it with the margin earned on those sales.
In practice
Real-world examples
Example 1
A building supplier sells $40,000 of materials on credit to a contractor, who then goes into liquidation and pays nothing. The supplier writes off the $40,000 against its allowance for doubtful debts, and reviews the credit terms it offers to similar customers.
Example 2
A medical practice has patients who owe $85,000 in total for services. Based on history, it expects 4% not to pay, so it records a bad debt allowance of $3,400 at year end.
Example 3
A wholesaler writes off a $7,500 invoice as bad debt, then six months later the customer settles in full after restructuring. The wholesaler reverses the write-off and records the $7,500 as a recovery. The finance team also reviews the customer's credit limit before accepting any further orders.
Think of it
Bad debt is like the money you know you'll never see again after lending to an unreliable friend. You have to accept the loss.
Formula
Calculation
Required allowance = Sum of (Receivables in each age band x Estimated loss percentage)
Bad debt expense = Required allowance - Existing allowance balance
Suppose a distributor has receivables of $500,000: $350,000 current, $100,000 that is 31 to 60 days overdue, and $50,000 more than 60 days overdue. It estimates losses of 1%, 5% and 20% respectively.
Allowance = (350,000 x 0.01) + (100,000 x 0.05) + (50,000 x 0.20) = 3,500 + 5,000 + 10,000 = $18,500, which is 3.7% of receivables. If the allowance account already holds $6,000, the bad debt expense for the period = 18,500 - 6,000 = $12,500.Case study
Seen in the real world
Eastbrook Office Supplies is an illustrative, fictional business with annual credit sales of $3,000,000. It had always written off bad debts only when customers formally failed, and annual write-offs averaged around $30,000.
In one year a major customer collapsed owing $180,000, which came as a shock because the profit for the year had already been reported to the bank. The bank questioned why no warning had been given, since the balance had been overdue for months.
The company adopted an allowance method with ageing bands, and introduced credit checks and limits for new accounts. In the illustrative aftermath, its profit figures were lower but steadier, and the bank regained confidence in the reporting. Bad debt fell to about 0.5% of credit sales within two years, and the sales team was asked to share responsibility for collecting from the customers it brought in.
Watch out
Common mistakes
- Waiting until a customer is declared bankrupt before recognising a problem, when overdue balances should be assessed and provided for earlier.
- Confusing bad debt with a discount or a credit note, which reduce the price of a sale, whereas bad debt is a failure to collect an agreed price.
- Treating bad debt as a purely accounting matter, when strong credit control and customer checks are what prevent it.
Questions
People also ask
What is the difference between bad debt and doubtful debt?
A doubtful debt is one that may not be collected and is covered by an allowance, while a bad debt is one confirmed as uncollectable and written off.
Where does bad debt expense appear?
In the income statement, usually within operating expenses, while the allowance reduces receivables on the balance sheet.
Can bad debts be claimed for tax?
In many jurisdictions they can, subject to conditions such as evidence of collection efforts, so the local rules should be checked.
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