Bad debt expense is the cost a business recognizes for accounts receivable it does not expect to collect. Selling on credit means accepting that some customers will not pay, and bad debt expense records that expected loss so profit is not overstated by revenue that will never become cash.
Two estimation approaches are used under the allowance method, and they answer the question from different directions.
Percentage of credit sales. Apply a historical loss rate to the period's credit sales. This targets the income statement and estimates the expense directly.
FORMULA
Bad Debt Expense = Net Credit Sales × Estimated Uncollectible %
EXAMPLE
A business with $2,400,000 in credit sales and a historical loss rate of 1.5% records $36,000 in bad debt expense for the period.
Aging of receivables. Apply escalating loss rates to each aging bucket to estimate the required allowance balance, then record whatever expense is needed to move the existing allowance to that figure. This targets the balance sheet and is generally the more accurate of the two.
EXAMPLE
Aging analysis indicates a required allowance of $41,000. The allowance account currently holds $12,000.
Bad debt expense = $41,000 − $12,000 = $29,000.
Note the expense is the movement needed, not the full $41,000.
The most common error in the aging method is recording the required balance as the expense, which double counts the allowance already carried.
Three separate entries arise, and they do different things.
EXAMPLE
Recording the estimate
Debit: Bad Debt Expense
Credit: Allowance for Doubtful Accounts
The expense hits the income statement and the allowance reduces net receivables. No specific customer is identified yet.
EXAMPLE
Writing off a specific account
Debit: Allowance for Doubtful Accounts
Credit: Accounts Receivable
Note that this entry does not touch bad debt expense. The cost was already recognized when the estimate was made.
EXAMPLE
Recovering a written-off account
First reverse the write-off: debit Accounts Receivable, credit Allowance for Doubtful Accounts.
Then record the receipt: debit Cash, credit Accounts Receivable.
The point that causes most confusion: under the allowance method, writing off a specific customer has no effect on profit. The profit impact happened earlier, when the estimate was booked.
The direct write-off method is not GAAP compliant for financial reporting, though it is permitted for US tax purposes, which is a common source of book-to-tax difference. Small businesses with immaterial bad debts sometimes use it in practice on materiality grounds.
Bad debt expense is an operating expense on the income statement, usually within selling, general and administrative expenses. Some businesses present it as a reduction of revenue instead, though as an expense line is more common.
It carries a debit balance, as all expense accounts do. It is not a contra account, though it is easy to confuse with one because its paired account is: the Allowance for Doubtful Accounts is a contra-asset that reduces gross receivables on the balance sheet.
On the cash flow statement, bad debt expense is added back to net income under the indirect method, because recognizing it consumed no cash.
For US federal tax, an accrual-basis business may generally deduct a bad debt only when it becomes wholly or partially worthless, not when an allowance is estimated. This means the tax deduction and the book expense usually fall in different periods.
Cash-basis taxpayers generally cannot deduct bad debts from unpaid invoices at all, because the income was never recognized in the first place, so there is nothing to reverse.
Treatment depends on the specific facts and the business's accounting method, so it is worth confirming with a tax advisor rather than applying as a general rule.
