Definition:
Bad-debt expense is the expense recognized on the income statement to account for the estimated amount of uncollectible accounts receivable. It’s a result of customers failing to pay their bills.
Key points about bad-debt expense:
- Allowance method: The most common method for accounting for bad debts is the allowance method, which involves creating an allowance for doubtful accounts.
- Direct write-off method: Another method, but less commonly used, is the direct write-off method, where bad debts are written off directly against the accounts receivable account.
- Matching principle: Bad-debt expense is recognized in the same period as the related credit sales, following the matching principle.
- Tax implications: Bad-debt expense can be deducted from taxable income, reducing a company’s tax liability.
Why is bad-debt expense important?
- Financial statements: Bad-debt expense is reported on the income statement as an expense, affecting a company’s profitability.
- Cash flow: Understanding bad-debt expense can help businesses manage their cash flow by anticipating potential losses from uncollectible accounts.
- Credit policy: Bad-debt expense can be used to evaluate the effectiveness of a company’s credit policy.
In essence, bad-debt expense is the expense recognized on the income statement to account for uncollectible accounts receivable, and it’s an important factor in financial reporting and cash flow management.
