Bad Debt Expense: Definition and Examples


Explore the intricacies of bad debt expense in this in-depth article. Learn about its implications for businesses extending credit, methods to estimate and calculate it, and its reporting on financial statements. Delve into examples, method differences, and Amazon’s approach. Understand the distinction between bad debt as an expense and a loss, and its placement within financial statements. Acquire a comprehensive comprehension of how bad debt expense shapes a company’s financial landscape.

Understanding bad debt expense

Bad debt expense plays a crucial role in the context of business credit transactions. It emerges when a receivable turns uncollectible due to a customer’s financial woes or bankruptcy. To mitigate this risk, companies allocate bad debts as an allowance for doubtful accounts on their balance sheets—a provision for potential credit losses. This article delves into the subtleties of bad debt expense and provides insights into its significance.

The challenge of uncollected debt

Whenever businesses extend credit to customers, they record accounts receivable—a commitment to future payment. However, there’s inherent uncertainty in realizing these funds. Bad debt expenses result from this uncertainty, necessitating an allowance for doubtful accounts. This enables businesses to adjust their net income and acknowledge the reality of uncollectible debt.

Matching principle and estimation

Adhering to the matching principle, accounting mandates that expenses align with corresponding revenues. To adhere to this, bad debt expenses must be estimated using the allowance method during the same period as the sale. Two primary methods—percentage sales and accounts receivable aging—are used to estimate this allowance. These methods ensure that potential losses are accounted for while preventing overstatement of income.

Calculating bad debt expense: methods unveiled

Two commonly employed methods are used to calculate bad debt expenses—the direct write-off and allowance methods.

Direct write-off method

The direct write-off method recognizes uncollectible accounts as they become uncollectible. While it’s used for income tax purposes, it diverges from GAAP’s matching principle. This approach lacks predictability and often records the expense in a period unrelated to the sale, making it less accurate for financial reporting.

Allowance method

The allowance method addresses the issue more systematically. It involves estimating the amount of uncollectible receivables based on historical data and industry trends. A contra-asset allowance account is created to offset accounts receivable, offering a more accurate financial portrayal. This method ensures alignment with the matching principle and better reflects a company’s financial health.

Estimating bad debt expense: Methods explored

Estimating bad debt expense involves either employing statistical modeling or relying on historical experience.

Statistical modeling

Statistical modeling uses default probability to predict losses due to delinquency and bad debt. Calculations are informed by historical data from the business and industry. This method considers the age of the receivable, with the percentage of uncollectibility rising as the receivable ages.

Accounts receivable aging method

The accounts receivable aging method categorizes outstanding accounts by age and assigns specific percentages to each category. This compilation yields an estimated uncollectible amount. By applying percentages to receivables of different ages, businesses gain a clearer perspective on potential losses.

Percentage of sales method

The percentage of sales method directly applies a flat percentage to the total sales for the period. By considering historical data, businesses gauge the portion of net sales likely to be uncollectible. This method provides a simple yet effective way to estimate bad debt expenses.

Amazon’s approach: a closer look

Scrutinizing Amazon’s financial reports offers insights into how companies handle bad debt. Amazon consolidates gross accounts receivable and the allowance for doubtful accounts in its financial statements. This approach reflects a conservative standpoint, mitigating the risk of overstatement.

Decoding bad debt: expense or loss?

Is bad debt an expense or a loss? The answer is both. Bad debt is categorized as an expense and reported alongside other selling, general, and administrative costs. However, its nature also shares characteristics with a loss account, as it reduces net income and impacts financial statements.


Here is a list of the benefits and drawbacks of understanding bad debt expense.

  • Enhanced Financial Insight: Grasping bad debt expense provides businesses with a clearer understanding of potential credit losses, enabling more accurate financial planning.
  • Improved Decision-Making: Companies armed with insights into uncollectible accounts can make informed decisions regarding credit extensions and risk management.
  • Accurate Financial Statements: Proper accounting for bad debt expense results in financial statements that better reflect a company’s true financial health.
  • Mitigated Overstatement: Employing the allowance method helps prevent overstatement of income, contributing to more reliable financial reporting.
  • Efficient Resource Allocation: By estimating bad debt, businesses allocate resources more effectively, aligning budgets with expected credit losses.
  • Complexity in Estimation: Estimating bad debt expense requires careful consideration of historical data and statistical modeling, which can be complex and time-consuming.
  • Inaccuracy in Direct Write-Off: Using the direct write-off method may lead to inaccuracies in financial reporting due to the lack of alignment with the matching principle.
  • Unpredictable Timing: The timing of recognizing bad debt using the direct write-off method can be unpredictable and unrelated to the sale.
  • Potential Loss of Revenue: Writing off bad debt can result in a loss of potential revenue that was initially accounted for as accounts receivable.
  • Impact on Financial Ratios: An increase in bad debt expense may negatively impact financial ratios, affecting creditworthiness and investor perception.

Reporting bad debt expense

Bad debt expense finds its place in the selling, general, and administrative expense section of the income statement. While its impact may be distributed across financial statements, the allowance for doubtful accounts sits on the balance sheet as a contra asset. Direct write-offs reduce accounts receivable, underscoring the need for meticulous accounting.

Frequently asked questions

Why is bad debt expense significant?

Bad debt expense underscores the reality of uncollectible receivables, reflecting the risk of extending credit to customers.

What is the allowance for doubtful accounts?

The allowance for doubtful accounts is a contra-asset account that offsets accounts receivable, providing a more accurate representation of a company’s financial position.

How does the percentage sales method work?

The percentage sales method estimates bad debt by applying a fixed percentage to the total sales, reflecting the expected portion of net sales that may become uncollectible.

How does Amazon handle bad debt?

Amazon combines gross accounts receivable and the allowance for doubtful accounts in its financial statements, adopting a conservative approach to financial reporting.

What’s the distinction between bad debt as an expense and a loss?

Bad debt is an expense that reduces net income and impacts financial statements. It shares characteristics with a loss account due to its effect on a company’s overall financial picture.

Key takeaways

  • Bad debt expense arises from uncollectible receivables due to bankruptcy or financial difficulties.
  • Allowance for doubtful accounts offsets accounts receivable to present a more accurate financial picture.
  • Methods for calculating bad debt include direct write-off and allowance methods.
  • Estimating methods encompass statistical modeling and historical experience.
  • Bad debt is an expense that reduces net income, impacting financial statements.
  • Amazon’s approach to bad debt involves conservative financial reporting.
View article sources
  1. What is bad debt provision in accounting? – Harvard Business School Online
  2. Allowance for Doubtful Accounts and Bad debt expenses – Cornell University Division of Financial Services Accounting
  3. Debt – SuperMoney
  4. What is an outstanding balance? Meaning and Examples – SuperMoney