Bad debt expense is the anticipated loss a company faces when some customers can’t or won’t pay their outstanding debts. This happens with sales made on credit, where, despite collection efforts, certain accounts remain uncollectible. These expected losses are recorded on the income statement as an operating expense, reducing the company’s net income to get a more honest view of profitability.
On the balance sheet, bad debt appears as a contra-asset account, directly offsetting accounts receivable.
Bad debt expense gives a realistic picture of a company’s finances by accounting for receivables that may never convert to cash. This adjustment prevents overstating assets and income, which is essential for trustworthy financial reporting. From a tax perspective, recording bad debts can lower taxable income, as these uncollected amounts are classified as expenses.
There are two main methods for estimating bad debt:
Note: The allowance method is the more popular choice under GAAP because it aligns with the matching principle, recording bad debts in the same period as the revenue they’re associated with.
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