Bad Debts Expense

A bad debts expense or uncollectable accounts expense is a loss that occurs when a business deliver goods or services on credit and the customer does not pay the bill when it becomes due. It is recorded as an operating expense in the income statement and deducted from the accounts receivable balance in the statement of financial position. There are two methods which are used for reporting the bad debts expense:

Allowance method

In this method the business estimates the amount of accounts receivable that will not be collected or recovered. The business will then post a journal entry in its books of accounts in which bad debt expense will be debited while an account named allowance for doubtful debts will be credited by the estimated amount of accounts receivable which the business expects to be not collected or recovered in the future. Allowance for doubtful debts is a contra asset account which is presented together with the company’s receivables on its statement of financial position.

For example, a company XYZ provides courier services worth of $80,000 to 5 different companies. The company XYZ discovers that one of its customers with the name of ABC which rendered services worth $15,000 is going through a difficult time financially which has caused the company XYZ to classify the amount receivable from ABC as a bad debt expense.

The company records the above mentioned bad debt expense in its books of accounts using the Allowance method and debits bad debt expense account by $15,000 and credits allowance for doubtful debts account by the same amount. When it will be confirmed that receivable from ABC is not going to be recovered then the company XYZ will post the journal entry in its books of accounts in which the allowance for doubtful debts will be debited by $15,000 and accounts receivable account credited by the same amount.

Direct write-off method

This method requires a customer balance deemed uncollectible to be removed from the company’s accounts receivable and the journal entry for it requires bad debt expense to be debited while accounts receivable to be credited.

For example, a company XYZ sells goods worth of $50,000 to 3 different customers. Company records $50,000 in revenue (to be presented on its statement of comprehensive income) and $50,000 in receivables (to be presented on the balance sheet). 

The company finds that one of its customers, ABC, will not be able to pay the $10,000 which it owes to XYZ and therefore it categorizes the said amount as a bad debt. The company records the above mentioned bad debt expense in its books of accounts using the Direct write-off method and debits bad debt expense account by $50,000 and credits receivable account of ABC by the same amount.