Bad debt expense refers to the estimated amount of uncollectible accounts receivable that a company expects to incur during an accounting period. This expense represents the portion of accounts receivable that a company estimates will not be paid by customers.
Bad debt expense is an important accounting concept that directly impacts a company’s profitability. By accurately estimating and recording bad debt expense, companies can report more realistic net income figures on their financial statements.
In this comprehensive 5000 word guide, we will cover everything you need to know about where bad debt expense appears on the income statement.
What is Bad Debt Expense?
Bad debt expense, also known as the allowance for doubtful accounts, is the estimated amount of accounts receivable that are expected to become uncollectible during an accounting period.
It is an expense that companies record in order to adjust accounts receivable to their realizable cash value. Accounts receivable represent amounts owed to a company by customers who purchased goods or services on credit.
However, not all customers end up paying their bills. Some customers may go bankrupt or simply refuse to pay. As a result, a portion of accounts receivable will become uncollectible.
Bad debt expense aims to account for these expected uncollectible amounts so that accounts receivable are not overstated on the balance sheet. Without properly accounting for bad debt expense, accounts receivable and net income would both be overstated.
Key Things to Know About Bad Debt Expense
Here are some key facts about bad debt expense:
– It is an estimated expense based on historical non-payment data and current customer credit profiles. Companies analyze aged accounts receivable reports and past loss rates to estimate bad debt.
– The estimated bad debt expense is reported on the income statement as an operating expense, which reduces net income.
– A corresponding contra asset account called allowance for doubtful accounts is created on the balance sheet that offsets accounts receivable. This allowance account represents management’s estimate of uncollectible AR.
– When actual customer accounts become uncollectible, they are written off against the allowance account rather than directly reducing accounts receivable.
– The beginning balance in the allowance account each period is adjusted based on the current period’s bad debt expense estimation.
Accurately estimating and recording bad debt expense provides more realistic financial statements and prevents accounts receivable being overstated.
Where Does Bad Debt Expense Appear on the Income Statement?
On the income statement, bad debt expense is reported as an operating expense, specifically under the selling, general and administrative expenses (SG&A) section.
The income statement shows a company’s revenues, expenses, and net income over a period of time. Here is an example income statement format:
Income Statement
| Revenues |
|---|
| Sales revenue |
| Total revenues |
| Expenses |
| Cost of goods sold |
| Selling, general and administrative |
| Depreciation and amortization |
| Total expenses |
| Income |
| Operating income |
| Other income/expense |
| Income before taxes |
| Income tax expense |
| Net income |
Bad debt expense is included within the selling, general and administrative (SG&A) expense section on the income statement. SG&A includes all operating expenses not directly tied to producing goods and services. Examples include salaries, rent, utilities, and bad debt expense.
Reporting bad debt expense as an operating expense provides a more accurate picture of the costs incurred during normal business operations. Failing to properly recognize bad debt would overstate net income on the income statement.
Why is Bad Debt Expense Part of SG&A?
There are a few key reasons why bad debt expense is specifically included in the selling, general and administrative (SG&A) section of the income statement:
1. Bad debt directly relates to sales and credit policies
Bad debt expense arises from a company’s credit sales to customers. The amount of estimated uncollectible accounts is directly driven by a company’s credit policies and terms, customer profiles, and collection procedures.
These credit and collection functions relate to general selling and administrative activities. Bad debt is a cost incurred when extending credit to customers during the sales process.
2. Bad debt is an operating expense
Bad debt is considered an operating expense for accounting purposes. Operating expenses are costs tied directly to central business operations and incurred in order to generate revenues.
This differs from financing or investing related expenses. Bad debt stems from core business functions like making credit sale transactions and collecting customer receivables.
3. SG&A is for indirect operating costs
The SG&A section includes operating expenses not directly tied to producing goods and services. These indirect costs support general business operations. Bad debt expense is not directly attributed to manufacturing products or delivering services.
Rather, it arises from administrative and selling activities and is therefore included alongside other SG&A operating costs like salaries, utilities, marketing, and insurance.
Bad Debt Accounting Journal Entries
There are two main accounting journal entries related to recording bad debt expense:
1. Bad Debt Expense Journal Entry
This entry records the estimated bad debt expense for the period in the general ledger. It is commonly done at the end of an accounting period after analyzing aged accounts receivable and estimating uncollectible amounts.
| Account | Debit | Credit |
|---|---|---|
| Bad Debt Expense | X | |
| Allowance for Doubtful Accounts | X |
The bad debt expense account on the income statement is debited, and the contra-asset allowance account on the balance sheet is credited. This increases expenses on the income statement and the allowance balance, while net accounts receivable remains unchanged.
2. Allowance for Doubtful Accounts Write-Off Entry
When a specific customer account is officially deemed uncollectible, it is written off against the allowance account.
| Account | Debit | Credit |
|---|---|---|
| Allowance for Doubtful Accounts | X | |
| Accounts Receivable | X |
The allowance account is debited, reducing its balance, while accounts receivable is credited directly. This nets the uncollectible amount against the existing allowance, rather than reducing accounts receivable directly.
Importance of Estimating Bad Debt Properly
It is very important for companies to accurately estimate and record bad debt expense each accounting period. Here are some key reasons why:
– Presents realistic accounts receivable balances
Recording bad debt expense offsets accounts receivable to their net realizable value expected to be collected based on past loss patterns.
– Avoids understating operating expenses
Recognizing bad debt as an operating expense affects the net income calculation and presents a more accurate picture of costs incurred.
– Impacts financial statement analysis
Trends in the bad debt expense and accounts receivable turnover ratios can provide insights into a company’s credit policies and collection efficiency.
– Reflects prudent accounting practices
GAAP accounting standards require the use of the allowance method to account for uncollectible accounts receivable.
– Prevents overstated profits
Not properly estimating bad debt would result in lower reported expenses and overstated net income on financial statements.
Methods to Estimate Bad Debt Expense
Companies generally estimate their bad debt expense each period using one of two primary methods:
1. Percentage of Sales
A set percentage is applied to total credit sales for the period.
– Simple and straightforward
– Uses historical bad debt rates
– May not reflect current financial conditions
2. Percentage of Receivables
The estimate is based on a percentage applied to ending accounts receivable.
– Considers aging of account balances
– Incorporates more current information
– More complex analysis required
The percentage of receivables method is commonly considered to be a more refined approach when applied properly. Companies may also utilize a hybrid approach or base estimates on historical loss rates adjusted for current customer collection trends.
Bad Debt Expense Example
Let’s walk through an example to illustrate estimating bad debt expense, recording the journal entry, and writing off an uncollectible account.
Company ABC has the following information:
– Total credit sales for the period: $1,000,000
– Ending accounts receivable balance: $100,000
– Past losses on uncollectible accounts: 2% of credit sales
Based on this history, Company ABC estimates that 2% of its current credit sales will also go bad.
Bad Debt Journal Entry:
| Account | Debit | Credit |
|---|---|---|
| Bad Debt Expense | 20,000 | |
| Allowance for Doubtful Accounts | 20,000 |
Bad debt expense is estimated at $20,000 (2% x $1,000,000 credit sales). The allowance account is credited for $20,000, the estimated amount of accounts receivable expected to be uncollectible.
Now, assume one customer with a $5,000 accounts receivable balance goes bankrupt. This account needs to be written off.
Allowance for Doubtful Accounts Write-Off:
| Account | Debit | Credit |
|---|---|---|
| Allowance for Doubtful Accounts | 5,000 | |
| Accounts Receivable | 5,000 |
The allowance account is debited to reduce the balance, while accounts receivable is credited directly for $5,000. Bad debt expense remains unchanged.
T-Accounts Example
T-accounts provide a visual representation of how bad debt accounting flows through the general ledger accounts.
Here is an example using T-accounts:
| Allowance for Doubtful Accounts | Bad Debt Expense | Accounts Receivable | |
|---|---|---|---|
| Beginning balances | $5,000 | $100,000 | |
| Bad debt journal entry | $20,000 | $20,000 | |
| Ending balances | $25,000 | $100,000 |
– The allowance account is credited for the estimated bad debt expense amount, increasing its balance.
– Bad debt expense operating account is debited for the estimation, affecting net income.
– Accounts receivable remains unchanged until specific write-offs occur.
This T-account example illustrates how bad debt accounting flows through the general ledger to provide more accurate financial statements.
Conclusion
Recognizing bad debt expense each accounting period provides a more realistic representation of net accounts receivable balances and profitability on the financial statements.
On the income statement, bad debt expense is included within the selling, general and administrative (SG&A) expenses section. This operating expense reduces net income and indicates the costs incurred from extending credit to customers during operations.
Estimating and recording bad debt involves analyzing historical loss rates, aged receivables reports, and current customer credit profiles. A contra allowance account is used on the balance sheet to offset gross accounts receivable to their net realizable value.
Careful bad debt expense estimation and recording is an important accounting principle that prevents the overstatement of revenues and assets. Understanding where it fits into the income statement is key for accurate financial reporting.
