How to Calculate Bad Debt Expense in 2025: Methods & Examples

Larry’s Lumber sends the shipment of wood to Terri’s Toys, as well as an invoice for $5,000. Due to unforeseen financial circumstances, however, Terri’s Toys cannot pay the invoice on time. Despite Larry’s Lumber attempting to collect the $5,000 several times, they decide that they are very unlikely to be successful. These operating costs effectively reduce the amount of income your company brings in, and can be tracked under your administrative expenses. A higher ratio signals poor credit control, suggesting that adjustments may be needed in credit approval processes, collection strategies, or customer vetting procedures.

Consider a roofing business that agrees to replace a customer’s roof for $10,000 on credit. The project is completed; however, during the time between the start of the project and its completion, the customer fails to fulfill their financial obligation. A debt becomes worthless when the surrounding facts and circumstances indicate there's no reasonable expectation that the debt will be repaid. To show that a debt is worthless, you must establish that you've taken reasonable steps to collect the debt. It's not necessary to go to court if you can show that a judgment from the court would be uncollectible.

This miscommunication leads to AR teams being out of step with customer needs and expectations, often driving up bad debt. Some argue that debt should be classified as an operating expense because it’s necessary to run the company. They argue that doubtful debt shouldn’t be reported as a liability because the money is owed to creditors and not to shareholders. For example, businesses can require higher credit scores, references, or upfront deposits before approving credit purchases. Additionally, setting reasonable credit limits and shorter payment terms (e.g., requiring payment within 30 days instead of 60 or 90 days) can help ensure that businesses receive payments on time.

Percentage of receivables

This per-capita figure helps illustrate the scale, though individuals don’t directly owe this amount. The number changes every day as the government borrows to fund its operations. 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. 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.

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How To Protect Your Business Against A Chargeback? 2025 Guide

It is a worrisome sign if the bad debt rate (the ratio of bad debt and AR in a year) is too high. On the surface, the reason behind it might seem to be limited only to the client, but how a company handles its AR also plays an important role. In this technique, the bad debt is directly considered as an expense, and the debt ratio is calculated by dividing the uncollectible amount by the total Accounts Receivables for that year. Ultimately, the best protection is to be proactive and recognize the signs of bad debt before it happens. Keep track of your customers' time-to-payment and see if they’re trending in the wrong direction.

Bad Debt Expense: How to Calculate and Manage Write-Offs

Bad debt expenses, if they get out of control, can significantly impact your profits. The good news is you can minimize bad debts by optimizing the way you manage your collections. In accrual accounting, companies recognize revenue before cash arrives in their accounts and must record expenses in the same accounting period the revenue originated. To minimize bad debt, companies must develop and enforce robust credit policies. This includes conducting comprehensive credit checks before extending credit and setting clear credit terms. Establishing strict credit approval criteria and regular credit reviews can significantly reduce the incidence of bad debts.

Reporting Bad Debts

This estimate is based on past data and observations and any anticipated events. On the balance sheet, bad debt expense is accounted for under accounts receivable through an adjustment called the Allowance for Doubtful Accounts. Instead of immediately reducing revenue, this allowance functions as a contra-asset account, which offsets total accounts receivable to show the estimated amount the company expects to collect. Recording bad debt expense also ensures compliance with the matching principle in accounting. This principle states that expenses should be recorded in the same period as the revenue they help generate. By estimating and recognizing bad debt in the same period as sales, businesses avoid sudden financial shocks when uncollectible debts accumulate over time.

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Understanding and mitigating these risks is essential for effective accounts receivable management and financial stability. Yes, if a customer pays after their debt has been written off, the amount is considered a bad debt recovery. The bad debt ratio measures the amount of money a company has to write off as a bad debt expense compared to its net sales. In other words, it tells you what percentage of sales profit a company loses to unpaid invoices. This is recorded as a debit to the bad debt expense account and a credit to the allowance for doubtful accounts.

This evaluation considers the customer's payment history, financial stability, and economic conditions. Timely identification of potential bad debts is crucial for effective receivables management. Bad debt expense is recorded as a contra-asset account on the balance sheet, which reduces the total value of accounts receivable. This adjustment ensures that the balance sheet reflects a more realistic view of the financial assets and their expected economic benefits.

This approach categorizes outstanding receivables by their age, such as 0-30 days, days, and over 90 days. Different uncollectibility percentages are then applied to each age category, with older receivables assigned higher percentages due to their increased likelihood of not being collected. The sum of these calculated amounts represents the estimated balance needed in the Allowance for Doubtful Accounts. A customer might file for bankruptcy, making them legally unable to repay their outstanding balances. Economic downturns or unforeseen financial hardships can also bad debt expense prevent customers from meeting their payment terms.

When handling disputes, AR teams can seamlessly loop in necessary team members to ease customer communication and tap into shared knowledge faster. Customers also receive full visibility into their outstanding balances and can seamlessly make payments through a cloud-based self-service portal. It’s also worth noting that your historical percentage of collections will likely vary between bullish and bearish economic cycles. If your company has enough business history to reference how collections performed in different economic cycles, this can be helpful for casting predictions. The allowance method is more complex on paper but paints a more accurate picture of your ability to collect invoices. According to the Generally Accepted Accounting Principles (GAAP), companies must follow this method due to the matching principle.

Unlike the income statement and balance sheet, bad debt expense does not directly impact cash flow. This is because bad debt reflects expected losses rather than actual cash transactions. However, excessive bad debts can cause cash shortages, making it harder for businesses to cover operational costs such as payroll, rent, and supplier payments. If it estimates that 2% of sales will be uncollectible, it records a bad debt expense of $10,000. Later, if a specific customer fails to pay a $3,000 invoice, the company reduces the allowance by that amount.

Companies retain the right to collect these receivables should conditions change. Bad debt results from a company’s inability to collect on amounts owed by their clients. Provisions for such debts are made by estimating what is expected to be collected. Over time, this provision should be created as these doubtful debts become apparent, using information like the number of days past due, the amount owed, and any other relevant information. Take your business to the next level with seamless global payments, local IBAN accounts, FX services, and more.

Saving Time with Reference Managers

Without it, financial statements could look healthier than they really are, misleading investors and decision-makers. Understanding its impact, accounting methods, and ways to prevent losses is key to staying financially stable. The allowance method, preferred under GAAP, estimates uncollectible accounts at the end of each accounting period. This method aligns with the matching principle by recognizing the expense in the same period as related credit sales. It establishes an “Allowance for Doubtful Accounts,” a contra-asset account that reduces Accounts Receivable’s net realizable value on the balance sheet. To record estimated bad debt, a company debits Bad Debt Expense and credits Allowance for Doubtful Accounts.

Most businesses will set up their allowance for bad debts using some form of the percentage of bad debt formula. If you do a lot of business on credit, you might want to account for your bad debts ahead of time using the allowance method. Like any other expense account, you can find your bad debt expenses in your general ledger. Not only does this help forge better customer relationships, but it also minimizes bad debt expense by reducing the likelihood of receivables becoming uncollectible. A collaborative AR tool like Versapay combines cloud-based collaboration features with what you’d expect from a first-rate accounts receivable automation solution.

Collaborative AR makes it easier for your AR staff to communicate with customers to clear up issues that often lead to payment delays, such as disputed invoice charges or missing remittance information. Instead of sifting through multiple email threads, AR staff and customers alike can find all the information they need in one place. Your finance team can use data to measure accounts receivable efficiency and report on performance more effectively. Tickmark, Inc. and its affiliates do not provide legal, tax or accounting advice. The information provided on this website does not, and is not intended to, constitute legal, tax or accounting advice or recommendations. All information prepared on this site is for informational purposes only, and should not be relied on for legal, tax or accounting advice.

• The adjustment value is the difference between the ending AFDA balance and the starting AFDA balance.
• Still, descriptions or abstracts are typically free and provide an overview of the article's content so you can make an informed decision about whether to spend money.
• Not only does it parse out which invoices are collectible and uncollectible, but it also helps you generate accurate financial statements.
• That’s why companies use bad debt expense—an accounting tool that helps them plan for money they might never receive.
• Bad debt expense reduces a company’s net income by accounting for receivables that are unlikely to be collected.
• The direct write-off method is a straightforward approach to accounting for bad debt.

This entails a credit to the Accounts Receivable for the amount that is written off and a debit to the bad debts expense account. Recording uncollectible debts will help keep your books balanced and give you a more accurate view of your accounts receivable balance, net income, and cash flow. We’ll show you how to record a journal entry for a bad debt expense a little later on in this post. Bad debt directly influences a company's financial health by impacting its net income. In accounting, bad debt is treated as an expense because it represents a loss of revenue.

• Regularly recording bad debt helps you stay ahead of cash flow issues and build more accurate budgets and projections.
• The allowance method estimates bad debt expense at the end of the fiscal year, setting up a reserve account called allowance for doubtful accounts.
• First, do a search for your their name, and see if they have a Citations profile.
• For example, by making it easier for Sales to access data on which customers are paying on time, late, and severely late, they can use it when negotiating credit terms with a customer.

Before we get into the ways to prevent and reduce bad debts, it’s important to understand why bad debts happen. Every business is different, but the following are some common reasons that contribute to bad debts in various industries. “In Europe and North America, non-collectible written-off revenues had risen to 2% before the pandemic,” says a McKinsey article.

As interest payments consume an increasingly large share of the federal budget, there’s less money available for all other government priorities. This can force difficult choices and lead to cuts in funding for public investments like infrastructure, education, and scientific research. While national debt may seem like an abstract macroeconomic issue, its effects trickle down and impact ordinary Americans’ financial lives in several tangible ways. The national debt isn’t a bill individuals pay directly, but it functions as an invisible, economy-wide headwind affecting personal finances. Today, the country faces an aging population, which drives up spending on Social Security and Medicare, slower projected long-term economic growth, and rising interest rates.