What it means
There are two ways to record it, and only one is generally acceptable in published accounts. The direct write-off method waits until a specific invoice is declared hopeless, while the allowance method estimates the likely loss upfront and builds a reserve against receivables.
The allowance method wins because of the matching principle, which says costs should appear next to the revenue that produced them. Writing off a January sale in November flatters January's margin and unfairly punishes November's.
The estimate itself comes from one of two routes. The percentage of sales approach applies a historical loss rate to credit sales, while the ageing approach applies rising loss rates to progressively older bands of the receivables ledger.
It is worth separating the expense from the reserve, since people use the terms loosely. Bad debt expense is a period figure in the profit and loss account, whereas the allowance is a running balance sitting against receivables on the balance sheet.
Under current accounting standards the estimate is forward looking rather than purely historical. Expected credit loss models ask companies to factor in what they already know about the economy and about specific customers, not simply what defaulted last year.
In practice
Real-world examples
Example 1
A building materials merchant selling on 60 day terms to small contractors charges a bad debt expense of about 2% of credit sales every year. It is treated as a predictable cost of offering credit, in the same way a retailer budgets for shoplifting.
Example 2
A software company selling annual subscriptions to large corporates books almost no bad debt expense, then charges $180,000 in one quarter when a single mid-sized customer enters administration owing four invoices.
Example 3
A finance team tightening cash flow reviews its ageing report monthly rather than annually. Spotting a customer sliding from 30 to 90 days early lets it stop further shipments before the exposure doubles.
Think of it
Imagine lending a friend money for lunch with the promise they will pay you back tomorrow. After six months of excuses, you finally accept they are not paying and cross it off your mental ledger as a loss.
Formula
Calculation
Required allowance = sum of (each ageing band x its expected loss rate)
Bad debt expense = required allowance - allowance balance before adjustment
A wholesaler has $920,000 of receivables at year end, split by age. Current invoices of $600,000 carry a 1% loss rate, giving $6,000. The 31 to 60 day band of $200,000 at 5% gives $10,000, the 61 to 90 day band of $80,000 at 15% gives $12,000, and the over 90 day band of $40,000 at 40% gives $16,000.
The required allowance is $6,000 + $10,000 + $12,000 + $16,000 = $44,000. After writing off specific invoices during the year, the allowance account already holds $18,000, so the top-up needed is $44,000 - $18,000 = $26,000. That $26,000 is the bad debt expense for the year, and receivables are reported net at $920,000 - $44,000 = $876,000.Case study
Seen in the real world
This is an illustrative and entirely fictional example. Thistledown Print, an invented commercial printer, grew sales 30% in a year by extending 90 day credit terms to smaller agencies that its competitors had refused. Revenue rose from $6,000,000 to $7,800,000 and the sales team collected their bonuses.
The finance manager, applying the ageing method, found the over 90 day band had grown from $60,000 to $340,000. Applying the company's historical 40% loss rate to that band alone produced $136,000 of required allowance from that band, and the total required allowance rose from $52,000 to $210,000. The bad debt expense for the year was therefore $158,000, against an incremental gross profit on the new sales of roughly $200,000.
In this fictional case the growth turned out to be barely worth having. The board introduced a credit limit policy, moved new agency customers to 30 day terms with a deposit, and rebased the sales bonus on cash collected rather than invoices raised.
Watch out
Common mistakes
- Waiting until a customer formally fails before recording any cost, which overstates profit in every period leading up to the default.
- Confusing the expense with the write-off, when writing off a specific invoice against an existing allowance has no effect on profit at all.
- Applying one flat loss percentage to the whole receivables ledger, ignoring that a 120 day invoice is far riskier than a current one.
Questions
People also ask
Where does bad debt expense appear in the accounts?
Usually within operating expenses, often inside selling or administrative costs rather than as a separate line.
Does writing off a debt mean giving up on collecting it?
No, the accounting write-off and the commercial decision to stop chasing are separate, and collection can continue for years afterwards.
Can bad debt expense be negative?
In effect yes, since recoveries or an over-provision in an earlier year can produce a credit that reduces or reverses the charge in the current period.