Definition of Bad Debts Expense
Bad debts expense is related to a company’s current asset accounts receivable. Bad debts expense is also referred to as uncollectible accounts expense or doubtful accounts expense. Bad debts expense results because a company delivered goods or services on credit and the customer did not pay the amount owed.
Examples of Bad Debts Expense
There are two methods for reporting 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 removed from Accounts Receivable and at that time the following entry is made: debit Bad Debts Expense and credit Accounts Receivable.
The allowance method anticipates and estimates 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 the estimated amount. (The Allowance for Doubtful Accounts is a contra asset account that when presented along with Accounts Receivable indicates a more realistic amount that will be turning to cash.)
For financial statement purposes 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. However, for income tax purposes the direct write-off method must be used.
