How To Calculate Bad Debt Expenses: A Comprehensive Guide

Debt is inevitable in business, and that’s not always a bad thing. Leveraging credit to invest in your company is a healthy way to induce growth. Borrowing money can even help keep a business afloat when cash flows slow. 

But when you offer goods or services to a client, you expect to get paid on time. Unforeseen circumstances can lead to delays in receiving payments, and sometimes, you can’t recover a debt at all. Calculating these liabilities is an important step toward balancing your business’s budget and planning for the future. 

Learn how to calculate your bad debt expenses with this comprehensive guide. 

What Is a Bad Debt Expense?

Bad debt expenses are the losses you incur when you can’t collect the debt someone owes you. In these situations, the company or individual owing the money can’t pay the agreed amount, whether that’s due to slow-moving funds or bankruptcy. You then have to calculate and acknowledge the debt as an expense in your ledger.

It’s unfortunate that some clients can’t pay you. But you still have to acknowledge that it happens—even if it doesn’t happen often. Accepting your losses and planning ahead for when bad debts come around lessens the blow.

Here’s an example. Imagine a company, Company X, has given Company Y the labor it needed to renovate its office. Company X sent Company Y an invoice at the end of the contract. But financial troubles took hold at Company Y before they settled their debt. 

A business in Company X’s position should make an honest effort to receive bad debt expense. These efforts might include sending reminders, calling the customer directly, and offering easier terms for repayment, like an installment plan. Despite these attempts to remind Company Y of its obligation, Company X can’t collect the money. In this case, Company X must add the loss to its total bad debt expenses.

FROM ONE OF OUR PARTNERS — When Customers Don’t Pay: A Guide to Accounts Receivable for Small Businesses

How To Calculate Bad Debt Expense

There’s more than one way to calculate a bad debt expense. Depending on your business goals, you can use any of the following methods: 

Write-Off Method

The write-off method works best if you have only a few small bad debts. You simply make a bad debt expense journal entry that reflects the amount owed. Just make sure the debts you intend to write off equal the value of the accounts receivable on your ledger. 

By entering these expenses case-by-case, you have a complete and accurate record for the IRS come tax season. The IRS lets you deduct bad debts if it’s clear the person owing the money won’t pay.

Allowance Method

If your business relies on credit sales, you may be able to estimate your bad debt expenses before they occur. Make an allowance for bad debt (ABD), creating a pool of money to draw from when clients don’t pay. This allowance is generally based on your past financial records. Accounting for bad debt beforehand ensures your business always has the cash it needs. 

Bad Debt Percentage Method

The bad debt percentage method is one way to estimate the size of the allowance you might need. The basic formula divides your total bad debts by your total credit sales: 

Total bad debts / total credit sales = future debt allowance

For example, if your business does $100,000 in credit sales this year and incurs $5,000 of bad debt, the formula is $5,000/$100,000 = 0.05 = 5%. In this example, you must create an allowance equal to 5% of its projected credit sales. 

If you haven’t been in business very long, it may be hard to accurately project credit sales into the future. In this case, you may need to adjust your estimate and recalculate your allowance when you better understand how your business performs. 

Aging Method

The aging method is another useful way to estimate your bad debt expenses. You divide bad debts by the credit sales within a designated age category. This helps you better understand the time it takes to collect on bad debt. Common invoice categories include 0–30 days old, 30–60 days old, and so on. Feel free to use lesser or greater intervals, depending on your needs. 

Separating your invoices by age allows each category to be assigned a bad debt percentage. This represents the likelihood of getting paid back. You can target earlier age categories with reminders and payment incentives and go for more extreme measures for older categories. The longer a debt remains unpaid, the less likely you can recover it.

RELATED ARTICLE — How To Follow Up on an Estimate (With Email Templates)

How To Record Bad Debt Expenses in a Journal Entry 

Journaling credits and debits is a common bookkeeping practice for most businesses. You can usually include bad debt expenses with other debits in your expense accounts.

Your journal may already have a section dedicated to expense accounts. If so, try to make room for bad debt as a category. An entry for bad debt simply lists the amount incurred. Reviewing these entries often can teach you how to find bad debt expenses and spot patterns. 

Take the time to add additional information to your journal, like the date of your unpaid invoice. This can help you calculate your bad debt expenses using the aging method. A separate accounting sheet may be necessary to outline your bad debt expenses by age. Adding the name of the business that owes you the money may also be helpful for tracking purposes. 

If you’re using the allowance method to calculate expenses, you may also want to make an entry for it in your ABD account. If you already have debts listed in your journal’s ABD, deduct each bad debt allowance from its total. Check up on your journal to see how your estimated allowance holds up after every week, month, or quarter. 

6 Pro Tips to Prevent Bad Debt Expenses

Sometimes, the best way to deal with bad debt expenses is to keep them from happening in the first place. Follow these tips to keep debt from hurting your budget:

1. Perform a Comprehensive Credit Evaluation

Before offering a large amount of credit to a customer, check their credit score. If you find they have a habit of racking up unpaid bills, you may want to think twice before entering into a credit contract. Start with smaller amounts and build trust before committing to amounts you might not get back.

2. Establish Transparent Credit Guidelines

Clear guidelines can help reduce confusion about when you expect payment and what penalties may apply when an invoice goes unpaid. Present the guidelines when you consult and make an initial estimate. And when you follow up on the estimate, make sure the terms of credit are clear to your customer.

3. Embrace a Proactive Approach to Collections

Even good companies miss payments sometimes. If a loyal client is late, you could offer an incentive, such as a reduced penalty. This signals that your company can be reasonable. By being proactive, you may be able to turn a customer with a single bad debt experience into a regular income source.

4. Facilitate Payment Arrangements

Payment arrangements can help remove bad debt from the expense column on your ledger. When someone struggles to make payments, granting a reduction in the interest or offering extra time may be all they need to catch up. You could also create an installment-based payment plan.

RELATED ARTICLE — How To Offer Financing as a Home Services Contractor

5. Track Your Customers’ Credit Status

You may have already run a comprehensive credit evaluation on a client. But if they’re a repeat customer, you may want to track their credit status over time. Tracking their score can give you the confidence to extend an advance or proceed with caution. 

Looking at customers’ credit scores may also help you prioritize your offerings. You can create tiered payment plans for clients with differing statuses. These tiers may include better interest rates for creditworthy customers. 

6. Automate Bookkeeping and Invoicing

Automation may be the best way to prevent bad debt expenses. With an automated bookkeeping service, preventative measures happen behind the scenes. Automatic invoice reminders and cash withdrawals free up your time and let you concentrate on paying customers. 

Bookkeeping Has Never Been Easier

Need help automating and organizing client payments? Upgrade your bookkeeping by syncing your Joist and QuickBooks Online accounts. Connecting Quickbooks with your Joist account lets you manage, organize, and automate all bookkeeping tasks in one place.

With Joist, you spend less time keeping records and more time impressing your customers. Let Joist keep your books organized so you can focus on what matters most: your business.