Bad Debt Expense Formula

What is Bad Debt Expense Formula?

Bad Debt expense is an expense recorded in financial statements when amount receivable from debtors are not recoverable due to inability of debtors to meet their financial obligation and can be calculated using direct method of allowance/estimation method.

Explanation of Bad Debt Expense Formula

If an organization does its business by selling goods on credit, it always had a risk of non-recoverability of such amount. This non-recoverability is known as Bad debt, and recording such amount as an expense is known as bad debt expense. Bad debt expensesBad Debt ExpensesBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation.read more equation can be recognized using two methods:

  • Direct Method
  • Allowance Method/Estimated Method

Direct Method

Under this method, the organization directly record bad debt expense when it occurs. However, this method is not generally used by the organization since this method does not uphold the matching principle stated in the “generally accepted accounting principleGenerally Accepted Accounting PrincipleGenerally accepted accounting principles (GAAP) are the minimum standards and uniform guidelines for the accounting and reporting. These standards prohibit firms from engaging in unethical business activities and enable for a more accurate comparison of financial reports to investors.read more.” As per this principle, expensesExpensesAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.read more for the revenue must be recognized in the same period in which they are booked.

Formula

Under the direct method, no formula is required since actual bad debts are recorded in books of accounts as an expense.

Allowance Method/ Estimation Method

Bed debts under this method recognize as a certain percentage of the sale made or outstanding debtors based on their aging and transfer such amount to a separate account known as Allowance for Doubtful debts. When an actual debtor becomes unrecoverable, such an account is debited, and the receivable account balance is reduced by crediting.

Bad debts under the allowance method can be calculated using two methods:

  1. Percentage of sale method
  2. Percentage of outstanding debtors

In the percentage of sale method, a certain percentage of the sale is recorded as bad debts expense during every accounting periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more based on past experience and future estimation.

Formula #1

Bad Debt Expense Formula = Sale for Accounting Period * Estimated % of Bad Debts

In the percentage of the outstanding debtorDebtorA debtor is a person or entity that owes money to the other party in a transaction. The receiver is referred to as the creditor, and the payment terms vary for each transaction based on the terms and conditions agreed upon by the parties.read more, a certain percentage of debtors is recorded as bad debt expense based on their aging or in simple word based on how old debtors are. For example, the company will record 1% as bad debts from debtors, which are not older than 30 days and 2.5% from debtors, which are not older than 60 days.

Formula #2

Bad Debt Expense = Outstanding Debtors based on aging * Estimated % of Bad Debts

These two methods are better illustrated with the help of the following examples.

Bad-Debt-Expense-Formula

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Examples of Bad Debt Expense Formula (with Excel Template)

Let us consider a situation to understand the examples of bad debt expense equation using a direct method.

You can download this Bad Debt Expense Formula Excel Template here – Bad Debt Expense Formula Excel Template

Example #1

Sale Expert Co. sold goods on credit to Mr. Smart, amounting to $ 1,200 on credit due in 7 days. After 5 days, the company got news of insolvencyInsolvencyInsolvency is when the company fails to fulfill its financial obligations like debt repayment or inability to pay off the current liabilities. Such financial distress usually occurs when the entity runs into a loss or cannot generate sufficient cash flow.read more of Mr. Smart as he is unable to pay his outstanding bank debts. Mr. Smart has confirmed that he will be unable to pay to sell expert co as he does not have enough resources to pay bank debt as well as sale expert co debt. What accounting treatment should be done by the company to record an unrecoverable debtor?

Solution

The company is certain that the amount receivable from Mr. Smart is no longer collectible due to his insolvency; the company should record such non-recoverability as expense in its financial statementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more.

Following journal entry should be passed:

ParticularsL.F NoDebit ($)Credit ($)
Bad Debt Expense Dr.1200
Account Receivable 1200
(Being Bad Debt Expense Recognized)

Now we will understand the bad debts expense treatment using the allowance method/estimation method:

Example #2

Future first Co. deals with FMCG products. Most of its sales happen on credit with an estimated recovery period of 15 days. The company recorded a sale of $ 145,000 during year 1. The company’s past trend shows that 2% of sales are not collectible.

Suppose in the next accounting period company recorded sales of $ 195,000. There is no change in its bad debt estimation. At the end of year 2, the company’s actual bad debt was $5000. Suggest the accounting treatment to be done if the company follows the allowance method of recording bad debt expenses.

Solution

First of all, we will calculate the bad debt expense to be recognized in year 1 & 2

Calculation of Bad Debt Expense

Example 2
  • =145000*2%

Bad Debt Expense will be –

Bad Debt Expense Formula Example 2.1
  • =2900

Bad Debt Expense for Year 1&2

Bad Debt Expense Formula Example 2.4
  • Bad Debt Expense for Year 1 = 2900
  • Bad Debt Expense for Year 2 = 3900

Total will be –

Example 2.5
  • =2900+3900
  • = $6,800

Accumulated balance in the allowance for doubtful debts at the end of year 2 follows –

Sr NoParticularsL.F NoDebit ($)Credit ($)
1Bad Debt Expense Dr.2900
Allowance for Doubtful Debts 2900
(Being Bad Debt Expense Recognized)
2Bad Debt Expense Dr.3900
Allowance for Doubtful Debts3900
(Being Bad Debt Expense Recognized)

Now actual bad debts are $5,000; the company will record the following journal entry –

Sr NoParticularsL.F NoDebit ($)Credit ($)
1Allowance for Doubtful Debts Dr.5000
Account Receivable5000
(Being Account Receivable Balance Reduced)

Example #3

Taking the concept of bad debt expense further, let us illustrate a situation where bad debt is recognized based on the aging of debtors. 

A local wholesale goods supplier supplies goods in wholesale to retailers. His past trend shows that from debtors not older than 30 days, 2% becomes bad. And from debtors who are older than 30 days, 3% becomes bad. This estimation remains the same for the current year as well. His debtors for the year is as follows:

  • 0-30 days = $ 76,500
  • More than 30 days = $ 82,500

Recommend the treatment to be done in books of accounts by the whole seller if he opts for the allowance method for recognizing bad debts.

Solution

First of all, we will calculate the number of bad debt expenses to be recognized:

Calculation of Bad Debt Expense

Bad Debt Expense Formula Example 3
  • =76500*2%

Bad Debt Expense will be –

Bad Debt Expense Formula Example 3.1
  • Bad Debt Expense = 1530

Bad Debt Expense for Year 1&2

Example 3.2
  • Bad Debt Expense for Year 1 = 1530
  • Bad Debt Expense for Year 2 = 2475

Total will be –

Bad Debt Expense Formula Example 3.4
  • = 1530+2475
  • Total bad debt expense to be booked  = $4,005

Journal entry to be recorded in books of accounts:

Sr NoParticularsL.F NoDebit ($)Credit ($)
1Bad Debt Expense Dr4,005
Allowance for Doubtful Debts4,005
(Being Bad Debt Expense Recognized)

Relevance and Use

Bad debt expense equation is an accounting procedureAn Accounting ProcedureThe accounting procedure is the process of standardized nature that performs a specific accounting function designed to incorporate better risk management policies to complete these functions efficiently. It includes billings, invoices to suppliers, bank reconciliation, requiring comprehensive and streamlined procedures.read more generally followed in the preparation of annual financial statements. Its relevance and use can be understood with the help of the following points:

  • Bad debt expense equation helps in obtaining a true and fair view of financial statements as net profit and debtors are correctly estimated by identifying bad and doubtful debts.
  • Bad debt expense recognized through the allowance method helps the organization to keep some funds aside for meeting future expenses.
  • The allowance method is based on the matching principle in accounting, so it affirms that financial statements have been made using generally accepted accounting principles.
  • Recovery of bad debts recognized as income in books of accounts as earlier it was recognized as an expense.

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