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Bad Debt Expense

Candlefocus Editor
Bad debt expense is an unavoidable cost of doing business for companies that extend credit to customers. It is the cost associated with uncollectible accounts that have been recorded for sales made on credit. Using the direct write-off method, companies record the exact amount of accounts assumed to be uncollectible when they are specifically identified as such. However, this method does not always conform to the matching principle as defined in generally accepted accounting principles. Therefore, in order to comply with the matching principle, bad debt expense must be estimated using the allowance method in the same period in which the sale occurs.

The allowance method of bad debts uses estimates to recognize bad debt expense in the period in which the origination sale was made. Using this method, companies create a contra asset allowance account that reduces the net amount of accounts receivable on the balance sheet. This allowance lowers the amount of net accounts receivables, recognizes bad debt expense in the period related to the origination sale, and reduces bad debt reported on the income statement.

There are two main ways to estimate an allowance for bad debts - the percentage sale method and the accounts receivable aging method. The percentage of sales method estimates a percentage of the sales for which credit is extended to become uncollectible. This method is beneficial for its simplicity and ease of implementation, but it ignores receivables aging and its accuracy may be impaired. In contrast, the accounts receivable aging method offers more accuracy in its estimates due to the fact that it takes into account the age of receivables when evaluating its collectability.

Bad debt expense is an inescapable part of doing business with customers on credit, and it carries substantial cost. It is important for companies to accurately estimate their allowance for bad debts in order to comply with the matching principle and provide a more realistic picture of their finances. Although techniques such as the direct write-off method exist, they are rarely used due to noncompliance with generally accepted accounting principles. The allowance method of bad debts uses estimates to recognize bad debt expense in the period in which the origination sale was made, but it requires careful evaluation in order to accurately estimate the amount of allowance and ensure that the matching principle is observed.

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