Bad debt expense is an important accounting concept that impacts a company’s net income and financial reporting. Determining whether bad debt expense should be recorded on the income statement requires analyzing factors like revenue recognition principles, the allowance method, and write-offs.
What is bad debt expense?
Bad debt expense refers to accounts receivable that are estimated to be uncollectible in the future. It represents revenue that has been recognized but cash is never received because customers fail to pay. Under the accrual basis of accounting, revenues are recorded when earned not when cash is received. If a sale is made on credit, the company must estimate how much of its accounts receivable will ultimately be uncollectible. This estimated uncollectible amount is recognized as bad debt expense on the income statement.
Revenue recognition principle
One of the core principles of accrual accounting is to match revenues and expenses in the period they are incurred, not necessarily when cash changes hands. Bad debt directly relates to revenue recognition and the principle of matching. Since companies recognize revenue at the point of sale, a portion of that revenue must later be written-off if customers never pay their bills. Bad debt expense is recorded so that revenues and expenses are properly aligned.
Allowance method
There are two approaches to account for bad debts – the direct write-off method and the allowance method. Under the direct write-off method, bad debt expense is not recorded until an account is specifically identified as uncollectible. The allowance method is preferable for financial reporting. Under this method, bad debt expense is estimated and recorded ahead of write-offs, through an contra-asset account called allowance for doubtful accounts. The allowance account has a normal credit balance and offsets the accounts receivable asset account.
Estimating bad debts
Companies analyze historical uncollectible percentages, industry benchmarks, and economic trends to estimate their future bad debt expense. Accounting rules require that bad debt expense be recorded in the same period as the related revenues, in adherence with the matching principle. So bad debts must be estimated and recorded in each period through the allowance method.
Writing off bad debts
After estimating and recording bad debt expense through the allowance, specific customer accounts must eventually be written-off. This occurs when invoices are past due for an extended period or customers declare bankruptcy. Write-offs decrease accounts receivable and the allowance account. The allowance covers the estimated expense, while the write-off represents the actual reduction of uncollectible receivables.
Impact of write-offs on financial statements
Bad debt write-offs do not go through the income statement. Since estimated bad debt expense has already been recorded, write-offs only impact balance sheet accounts. The allowance account is reduced by credits, while accounts receivable is directly reduced through debits. The income statement was impacted earlier when bad debt expense was estimated and recognized.
Bad debt expense on the income statement
To summarize, under the allowance method, estimated bad debt expense flows through a contra-revenue account on the income statement. This matches it against sales in the same period. The estimated bad debt expense reduces net income. When specific accounts are directly written-off later, only balance sheet accounts are affected.
Role of management estimates
Estimating bad debts requires significant judgement. Management must analyze historical trends, economic factors, industry data, and overall collectability of receivables to estimate uncollectible percentages. If estimates are too low, bad debt expense is understated. If estimates are too high, net income is understated. Auditors scrutinize the adequacy of a company’s bad debt allowance during financial statement audits.
Bad debt expense examples
Here are some examples to illustrate recording bad debt expense:
- Company A has $100,000 of credit sales during the year. Historical data shows 2% of credit sales are typically uncollectible. Company A records bad debt expense of $2,000 (= $100,000 x 2%) through a credit to the allowance account on the income statement. This reduces net income.
- Company B has $500,000 of accounts receivable at year end. 9% of receivables are estimated to be uncollectible based on aging analysis. Company B records bad debt expense of $45,000 (= $500,000 x 9%) through a credit to the allowance account, reducing net income.
- Company C writes off $10,000 of accounts receivable because a customer filed bankruptcy. The write-off is recorded by debiting the allowance account and crediting accounts receivable $10,000. The income statement is unaffected, only the balance sheet accounts change.
Conclusion
Bad debt expense recorded under the allowance method flows through the income statement, reducing net income. Writing off specific uncollectible accounts only impacts balance sheet contra-asset accounts. The key takeaway is that estimated bad debt expense hits the income statement when revenue initially occurs. This matches expenses with revenues per accrual accounting concepts.
