Bad Debt Expense

A business is always at risk so many times, one of these risks is offering goods and services on credit to customers who may likely fail to pay up. It’s a personal choice for a business to write off certain unpaid customer invoices. However, a business can be left with no choice but to write-off unpaid invoices and render them as bad debt when a customer is no longer able to pay a debt or no longer responds to calls regarding unpaid invoices. Writing off debts may cost your business, however, it prevents you from overstating your revenue and earnings from those assets.

What is Bad Debt Expense?

The term bad debt expense stems from ‘Bad Debt' it is used to refer to a receivable that is no longer collectible—that is, when a customer is not able to fulfill their end of a credit bargain by paying all outstanding debt as a result of current financial problems they may be facing. In such a case of failure to pay a loan due to financial problems companies that extend credit duration are likely to report bad debts for doubtful accounts on their balance sheet. Bad debt expense always happens as a result of a company delivering goods to a customer on credit with the hope that the customer would pay back at the agreed time, but the customer never gets to pay back.

Types of Bad Debts Expense

Just like bad debt, bad debt expense can be reported using to methods; the direct write-off method and the allowance method.

• Direct write-off method: This requires that an uncollectible account be taken out of Accounts Receivable and another entry made; the debit Bad Debts Expense and credit Accounts Receivable entry.

• Allowance method: This method does not wait until an account is uncollectible before it takes drastic steps, rather it anticipates and estimates possible receivables that will become uncollectible. In other words, though the company may not be certain about which accounts would end up uncollectible the company would go ahead to debit Bad Debts Expense and credit Allowance for Doubtful Accounts for the stipulated amount.

For the purpose of financial statement, the allowance method is preferable to the direct write-off method. The reasons being that a more realistic amount will be reported on the balance sheet, and the bad debt expense will be reported on the income statement. While for income tax purposes the direct write-off method is preferable to the allowance method.