It seems odd to envision a “bad” debt when debt generally isn’t viewed as a positive. Of course, that’s a different story if you’re the debt holder. A good debt accounts for money that you can reasonably expect to receive in the near future, while a bad debt reflects owed funds that will likely never be paid.
So, if you want your business to fully understand its actual financial standing — as opposed to what it might look like in a best-case scenario — tracking and managing these bad debts is critical. In this article, we’ll explore bad debt expense, why it happens, and how to manage it effectively.
What is bad debt expense in accounting?
Under the accrual accounting model, when a sale is made, you immediately record the value in your financial records as a credit to your revenue and a debit to your accounts receivable (A/R). And when the funds for the sale are received, that debit shifts out of the A/R account.
However, as unpaid invoices begin building up, you can’t just let your bad debt accrue and skew the value of your accounts receivable. Instead, when you realize that a debt is likely never to be paid, you would move it from your A/R account to your bad debt expense account on your financial records. As such, the bad debt expense serves as a reduction against your net income for accounting purposes.
By contrast, if you’re using the cash accounting method, you’ll never need to concern yourself with bad debt expense since you’d only record revenue when you receive cash.
How to calculate and record bad debt expenses
If you operate your business in the U.S., the Internal Revenue Service (IRS) dictates that a bad debt should only be recognized if you have strong evidence that the customer will not pay and you have taken reasonable steps to collect on the debt. But no matter where you are located, bad debt expense is recorded on both your balance sheet and income statement — particularly under the sales, general, and administrative (SG&A) section. And to determine what value should be listed on this line item, you can use one of two different models.
Direct write-off method
For the direct write-off method, as you determine that individual invoices will likely never be paid, you would immediately note the value shift in your A/R and bad debt expense accounts. Since this strategy records the exact amount of uncollectible debt, you’ll want to use this approach when calculating your U.S. income taxes.
However, depending on how long your dunning efforts take, when you use this model, you run the risk of recording your accrued bad debt in a separate reporting period than the actual sale — which would violate the matching principle of accrual accounting. As such, this matching failure means that the direct write-off method doesn’t meet generally accepted accounting principles (GAAP), so bear that fact in mind when you choose to use it.
Allowance method
Rather than relying on real-time decisions to rein in the overstatement of potential income, this strategy instead uses estimates created at the end of each reporting period to predict the likelihood of bad debt occurring. And since these estimates leverage historical data from the same period, the allowance method allows your business to remain GAAP compliant.
In more detail, alongside your bad debt expense account, you would also create an allowance for doubtful accounts (AFDA) on your income statement and balance sheet. This AFDA account would then record the estimated bad debt, serving as a contra-asset account for your A/R.
Using the allowance method to estimate bad debt expenses
To create the appropriate estimate for your AFDA account, there are three different approaches you might use:
1. Percentage of sales
For this strategy, you would first analyze your historical data — typically focusing on the preceding reporting period — to determine the ratio of how much of your total sales resulted in bad debt. You would then apply this percentage to your actual sales in the current period to create your estimate.
Bad Debt Expense = % of Historic Sales Estimated To Be Uncollectible x Actual Credit Sales
2. Percentage of receivables
While similar to the previous strategy, this approach focuses on your A/R rather than total sales. So, you’ll initially identify what proportion of your average accounts receivable in the preceding reporting period was ultimately determined to be uncollectible. You’d then apply this percentage against your current receivables balance.
BDE = % of Historic Receivables Estimated Uncollectible x Current Receivables Balance
3. Accounts receivable aging
In many ways, this method is an extrapolation of the percentage of receivables strategy. However, for the accounts receivable aging method, rather than determining a bad debt percentage for all of your historical A/R, you’ll individually identify a corresponding bad debt percentage for each category within your accounts receivable aging report. As you apply those unique percentages against your current A/R aging categories, you can add the sums to determine the value you’ll need to record in your AFDA contra account.
Bad Debt Expense | = | Estimate of Uncollectible Receivables (Current) | + | Estimate of Uncollectible Receivables (30+ days) | + | Estimate of Uncollectible Receivables (60+ days) | + | Estimate of Uncollectible Receivables (90+ days) |
Bad debt expense example
MAC Ready Research operates a specialized laboratory in Antarctica, which contracts out to “alternative” science organizations for research projects and experiments. Over the past several months, the research station has only worked with its three most industrious clients: The Flat Earth Alliance, Cthulhu Inc., and It’s Not a Flat Earth…It’s a Hollow Earth Foundation.
At the end of 2023, the three organizations were sitting on $85,400, $34,000, and $34,450 outstanding invoices, respectively. And wanting to account for the potential bad debt hiding in these listed assets, MAC opted to use the allowance method — particularly the accounts receivable aging strategy — to determine its bad debt expense.
After pouring over its records for the preceding months, the research lab determined the corresponding bad debt ratios for its A/R totals based on how long the debts had been outstanding. Armed with this information, MAC created a modified A/R aging report.
Company | Current | 30+ days | 60+ days | 90+ days | Total: |
Flat Earth Alliance | $42,700 |
| $42,700 |
| $85,400 |
Cthulhu Inc. |
| $18,000 |
| $16,000 | $34,000 |
It’s Not a Flat Earth | $12,450 | $5,000 | $17,000 |
| $34,450 |
Total: | $55,150 | $23,000 | $59,700 | $16,000 | $153,850 |
Default probability: | 0.5% | 4% | 9% | 13% |
|
Bad debt total: | $275.80 | $920 | $5,373.0 | $2,080 | $8,648.80 |
By applying its historical bad debt percentages against the current buckets in the report and adding these totals, the lab determined that the value it should record as bad debt expense on its income statement and balance sheet was $8,648.80.
Why do bad debt expenses occur?
While it might be difficult to identify why some invoices are never paid, there are some common issues that you should be on the lookout for, such as:
- Bankruptcy: If your customer doesn’t have the money to pay you or it’s tied up in bankruptcy proceedings, you’re much less likely to close out that invoice, so you should actively monitor the financial health and credit history of any large buyers.
- Errors: Despite your best efforts, you’re not going to get everything right on your invoices, and when that happens, your customers will often hold up payment until the problem is resolved. So make sure you resolve it.
- Fraud: Unfortunately, there are some bad apples out there, and if you don’t have sufficient anti-fraud measures in place, you risk making sales to parties that have no interest in ever paying you.
- Miscommunication: If there is any confusion regarding credit or payment terms, you should quickly resolve this misunderstanding before it leads to a bad debt.
- Payment failures: Unforeseen and uncontrollable processing issues sometimes occur when accepting credit card — or other — payments, and if your dunning management efforts are lacking, it’s possible that you’ll never actually receive those funds.
Managing bad debt expenses with accounts receivable automation
Keeping bad debt to a minimum should be a priority for every business. One of the strongest measures to offset these potential write-offs is prioritizing efficiency and accuracy throughout your A/R efforts.
There are several measures you can take to help simplify and streamline these critical processes. Still, we here at Invoiced believe that shifting to an automated accounting platform will give you the best results for your investment.
1. Automated collections processes
The right software will provide you with centralized workflows to cut out unnecessary wait times by automatically routing invoices through the relevant creation, validation, and collection processes with minimal human intervention.
In particular, when you automate your dunning efforts you can cut out labor costs while ensuring that outstanding invoices remain at the front of your customers’ minds.
We also recommend that you consider a solution that offers e-invoicing capabilities — a move that can accelerate communication and payment processing. Since the likelihood of receiving a payment decreases as more time passes from the initial product or service delivery, prompt and accurate invoicing will help reduce the chance of incurring a bad debt.
See: Invoiced’s automation software capabilities — including chasing and dunning.
2. Clarified credit policies
Many automation platforms include a payment portal that allows users to track and manage their purchases and payments directly. Not only does this functionality make life easier for buyers, but you can typically leverage this capability to supply your customers with clearly defined credit and payment terms and even offer them the ability to request changes.
You should also clearly document these terms on the individual invoice and any corresponding communications to further help avoid confusion.
3. Improved insight into customer credit health
Analytics can be an incredibly powerful tool in making smart choices regarding credit policies and even which customers you should work with. While manual accounting processes leave you with little information to consider when making these critical decisions, an automated platform can provide you with a broad range of data and metadata that can unlock previously undiscovered insights.
At the same time, many solutions also incorporate automated credit checks into process workflows that can deliver near real-time insight into the overall financial health of your current and potential customers.
See: Invoiced’s analytics capabilities — including pre-built reports, cash collection forecasting, and more.
4. Integrated invoicing
When considering potential automation software, you should search for an offering with extensive integration capabilities. By avoiding manual data transcription between systems and applications, you can dramatically reduce the likelihood of human error undermining the accuracy of your invoices. And with more accurate statements sent out, your customers will have fewer reasons to dispute invoice totals and delay payment.
See: Invoiced’s integration capabilities — including Netsuite, Sage Intacct, Quickbooks, Xero, specialty integrations, custom integrations through ERP Connect, and more.
5. Simplified implementation for early payment discounts
One rather effective strategy to repel bad debt is offering early payment discounts encouraging buyers to close out their invoices well before the initial due date. Of course, accurately applying these discounts — particularly if you use a dynamic or sliding-scale approach — can quickly become complicated.
But with the right automation platform in place, the technology will make the relevant adjustments for you.
See: Invoiced’s payment capabilities – including early payment discounts, flexible payment plans, virtual card processing, AutoPay, and more.
6. Streamlined relationship building
Many of the functions and features we’ve already discussed can make life a lot easier for your customers. When your business is not only easy to work with but also makes all of the data necessary for invoice tracking and validation are readily available — through e-invoicing and payment portals — to buyers, your customers are much more likely to overlook and work through minor issues, getting you paid quickly and consistently.
Make bad debt a rarity with Invoiced
Many financial and operational advantages can be captured through automation, but not all platforms can deliver the same scope and quality of features Invoiced offers.
Our Accounts Receivable Automation software can make even the most complex invoices — such as those featuring international transactions, early payment discounts, and convenience fees — an easy task for your accounting team. Meanwhile, our Smart Chasing technology will simplify and accelerate your dunning efforts to help ensure you get paid promptly.
This is just the tip of the A/R iceberg. To see our platform in action and get the full picture of what we can do for you, schedule a demo today.
