What is Bad Debt? The Method of Bad Debts Written Off and Protection​

Basically, bad debt is an irrecoverable receivable: a type of expense that occurs when a customer to whom you have extended credit is no longer able or willing to pay you. In accounting terms, this is known as a “bad debt expense” which must be charged against your company's accounts​. 

Cash flow management is the lifeblood of any business so anything that reduces cash flow could jeopardize business success or even its survival. Any company that extends credit to its customers is at risk of slower or reduced cash flow if any of that credit turns into bad debt expense. Although some level of bad debt expense is often unavoidable, there are steps companies can take to minimize bad debt expense.

When a customer defaults on its bills or is in danger of doing so, the company extending credit to that customer faces a bad debt expense. Bad debt expense reflects the amount of accounts receivable that a company is unable to collect now and may not be able to collect in the future. Because this bad debt expense must be charged against the company's accounts receivable, bad debt expense reduces the amount of accounts receivable on the company’s income statement.

There are many examples of companies dealing with bad debt expense. One company changed its approach to bad debt management after two major clients defaulted on their bills, leaving the company facing tens of thousands of dollars in losses. To make matters worse, the company had also dedicated considerable staff time and resources trying to collect on those bad debts with no success. By purchasing credit insurance, the company not only protected itself against future losses from bad debt, but it also was able to leverage that protection as it pursued growth with new customers.

Is Bad Debt an Expense?

A bad debt expense is typically considered an operating cost, usually falling under your organization’s selling, general and administrative costs. This expense reduces a company’s net income over the same period the sale resulting in bad debt was reported on its income statement.

Bad debt expense is calculated as a percentage of total accounts receivable. To calculate bad debt expense, divide the total dollar amount of all accounts receivable by the total dollar amount of bad debt then multiply that number by 100. For example, a company with $1 million in accounts receivable and $50,000 in bad debt would calculate bad debt expense using this bad debt expense formula:

Typically, the allowance method of reporting bad debts expenses is preferred. However, it’s important to know the differences between these two methods and why the allowance method is generally looked to as a means to more accurately balance reports.

Direct Write-Off

When reporting bad debts expenses, a company can use the direct write-off method or the allowance method. The direct write-off method reports the bad debt on an organization’s income statement when the non-paying customer’s account is actually written off, sometimes months after the credit transaction took place. Company accountants then create an entry debiting bad debts expense and crediting accounts receivable.

In general, accounting departments do not use the direct write-off method for bad debts expense, as the company’s balance sheet would be likely to report an amount greater than the actual collectable amount and the bad debts expense may be reported in the company’s income statement for the year after the sale. Instead, accountants typically apply the allowance method.

Allowance Method

Using the allowance method, accountants record adjusting entries at the end of each period based on anticipated losses. At the end of each year, companies review their accounts receivable and estimate what they will not be able to collect. Accountants debit that amount from the company’s bad debts expense and credit it to a contra-asset account known as allowance for doubtful accounts.

When accountants ultimately write off an accounts receivable as uncollectible, they can then debit allowance for doubtful accounts and credit that amount to accounts receivable. Using this method allows the bad debts expense to be recorded closer to the actual transaction time and results in the company’s balance sheet reporting a realistic net amount of accounts receivable.

While a company is unlikely to avoid bad debt expense entirely, it can protect itself from bad debt in a number of ways such as allowance for bad debts. Another way is for companies to set various limits when extending customer credit to minimize bad debt expense. Such limits can be set to manage existing and potential bad debt expense overall and for specific customers. For example, a company could dictate tighter credit terms based on each customer’s unique circumstances. In some cases, a company might avoid extending credit at all by requiring a buyer to procure a letter of credit to guarantee payment or require prepayment before shipment.

In some cases, companies may also want to change the requirements for extending credit to customers. For example, if customers in a certain industry or geographic area are struggling, companies can require these customers to meet stricter requirements before the company will extend credit. The same strategy could be used to manage credit for customers that have outstanding debts over a certain amount or that are a certain number of days late on their bills.

Companies can obtain bad debt account protection that provides payment when a customer is insolvent and is unable to pay its bills.

However, because there are reasons other than insolvency for customer nonpayment, this type of bad debt account protection is of limited use for most companies.

If bad debt protection does not fit a company’s needs, there are alternatives. The best alternative to bad debt protection is 

trade credit insurance, which provides coverage for customer nonpayment in a wide range of circumstances.

The best trade credit insurance also provides credit data and intelligence designed to help companies improve their credit-related decision making and credit management. The goal is to prevent losses from bad debt. Since no company can avoid bad debt entirely, the trade credit insurance policy is in place to cover any losses that occur even after the company and the insurer have taken steps to minimize losses.

While bad debt protection only covers “losses from customer insolvency,” trade credit insurance covers “protracted default,” which is when a solvent company is late with its payment or simply fails to pay at all.  A large, specialty trade credit insurance carrier can also tailor a policy to cover many other eventualities, including:

1. Unpaid invoices as a result of natural disaster
2. Unpaid invoices as a result of political risk; for example, when doing business in other countries
3. Losses that occur as a result of problems before goods are shipped; for example, this could involve custom-produced goods that cannot be sold to another customer
4. Losses occurring after shipment by a contracted third party
5. Losses occurring when selling on consignment terms