Bad debts expense often refers to the loss that a company experiences because it sold goods or provided services and did not require immediate payment. The loss occurs when the customer does not pay the amount owed. In other words, bad debts expense is related to a company's current asset accounts receivable.
It is common to see two methods for computing the amount of bad debts expense:
- direct write-off method
- allowance method
The direct write-off method requires that a customer's uncollectible account be first identified and then removed from the account Accounts Receivable. This method is required for U.S. income taxes and results in a debit to Bad Debts Expense and a credit to Accounts Receivable for the amount that is written off.
The allowance method anticipates that some of the accounts receivable will not be collected. In other words, prior to knowing exactly which customers or clients will not be paying, the company will debit Bad Debts Expense and will credit Allowance for Doubtful Accounts for an estimated, anticipated amount. (The Allowance for Doubtful Accounts is a contra asset account that when combined with Accounts Receivable indicates a more realistic amount that will be turning to cash.)
Many believe that the allowance method is the better method since 1) the balance sheet will be reporting a more realistic amount that will be collected from the company's accounts receivable, and 2) the bad debts expense will be reported on the income statement closer to the time of the related credit sales.