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 expenses 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, expenses 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:
- Percentage of sale method
- 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
In the percentage of the outstanding debtor, 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
These two methods are better illustrated with the help of the following examples.
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For eg:
Source: Bad Debt Expense Formula (wallstreetmojo.com)
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.
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 insolvency 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 statement.
Following journal entry should be passed:
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
- =145000*2%
Bad Debt Expense will be –
- =2900
Bad Debt Expense for Year 1&2
- Bad Debt Expense for Year 1 = 2900
- Bad Debt Expense for Year 2 = 3900
Total will be –
- =2900+3900
- = $6,800
Accumulated balance in the allowance for doubtful debts at the end of year 2 follows –
Now actual bad debts are $5,000; the company will record the following journal entry –
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
- =76500*2%
Bad Debt Expense will be –
- Bad Debt Expense = 1530
Bad Debt Expense for Year 1&2
- Bad Debt Expense for Year 1 = 1530
- Bad Debt Expense for Year 2 = 2475
Total will be –
- = 1530+2475
- Total bad debt expense to be booked = $4,005
Journal entry to be recorded in books of accounts:
Relevance and Use
Bad debt expense equation is an accounting procedure 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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