Is a Bad Debt expense an Operating expense?

Businesses often have to grapple with the problem of Bad debts. Bad debt is the amount not realized from the sales of products or services. It could also be the loan amount or interest not recovered from a borrower by a financial institution. When a business sells a product or service on credit, the business may allow the buyer to pay the amount after a stipulated period such as one week or one month, etc. If the buyer fails to compensate the seller within the accounting period then the amount not received is written off as bad debt at the end of the accounting period. Also, the amount not recovered from the borrower within the accounting period is considered a bad debt at the end of the accounting period.

Is Bad Debt an Operating Expense?

Bad debt is an operating expense because it is the amount not recoverable from the borrower during the day-to-day functioning of the business. It is the expense incurred by the business while engaging in its routine activities. It is the expense incurred by the business while engaging in its primary business activities.

Treatment of Bad Debt

According to GAAP ( Generally Accepted Accounting Principles), businesses have to make a provision for bad debts before the debt goes bad. This provision may also be referred to as Allowances for Doubtful Accounts. The provision is to be made because GAAP requires that businesses present a realistic and accurate picture of their finances. There are two approaches to making provisions for bad debts:

1. Sales Method.
2. Accounts Receivable Method.

According to the Sales Method, provision for bad debts is made as a percentage of credit sales. If the credit sales of a business in an accounting period is 1 million USD and if the business knows from empirical evidence that 2 percent of the credit sales are likely to turn bad, then it will make a provision of 20 thousand USD towards bad debts.

The Accounts Receivable Method takes into consideration the period for which the debt has been outstanding. Under this method, a smaller percentage of the outstanding amount will be provisioned as bad within a specific period. As the period of outstanding increases, a higher percentage of the outstanding amount is provisioned as bad and doubtful.

The percentage of credit sales to be provisioned as bad is based on empirical evidence of the business. The business will consider the bad debt percentage in previous years to decide on an appropriate percentage for provisioning. New businesses may choose a percentage based on industry averages.

Actual Write off of Bad Debts

When bad debt occurs, I.e. when the business realizes that it won’t be able to recover a certain amount from the borrower or buyer for sure, the business will reduce the Provision for bad debts as well as the Accounts Receivable to the extent of the amount that has been confirmed bad.

Examples of Bad Debt expense

• Amount not recovered during the financial year from your debtors, for goods sold to them on credit, is an example of bad debt.

• Credit card dues and interest on it not recovered by the bank before the end of the financial year is an example of bad debt.

• Any loan EMI outstanding at the end of the financial year is an example of bad debt from the perspective of the bank.

How to calculate bad debt expense?

Let us discuss a couple of examples of bad debt and how to calculate bad debt expenses.

1. You are a machine tools manufacturer. You sell your products to distributors and end-users and offer them a credit period of 30 days for repayment. A couple of your distributors have not returned your money after the stipulated period of 30 days. The total amount outstanding is 25000 dollars. You wait for them to pay but they don’t pay you and after a few months, you realize that you will never be able to recover the money. The reason for non-payment could be anything and you are not affected by the reason for non-payment. Your concern is that you have not received the dues you are entitled to. Based on experience you have already allocated 2 percent of your projected annual sales amount to provision for bad debts. At the end of the financial year, you will reduce 25000 dollars from your Accounts Receivables as well as from the Provision you have made for bad debts, thereby writing off the amount. Assuming that your annual revenue from credit sales is 10 million dollars, 2 percent provision for bad debts will amount to 200 thousand dollars. You will write off 25 thousand dollars from the provision for bad debts.

2. Let us assume that you have borrowed 30 thousand dollars from a bank to buy a car on a five-year term. The interest rate is 9 percent per year. The monthly amount payable to the bank ( EMI: Equated Monthly Instalment) is 622.75 dollars. You are unable to pay 3 EMI’s during the year because of some financial constraints. Your account goes into default and the bank will report your default status to credit bureaus. If you are unable to pay this amount till the end of the financial year, your bank will mark this amount as a bad debt expense ( 622.75 * 3 = 1868.25 dollars). It doesn’t mean that your bank will write off the entire amount lent to you. They will pursue you till you repay the outstanding amount and resume repayment of your EMI.

Where does bad debt appear on the Income Statement and Balance Sheet?

Bad Debt expenses are directly charged in the Income Statement under the Sales and General Administrative expenses section or a Provision for Bad debts or Allowances for doubtful accounts is created under the same section in the Income Statement. In the Balance Sheet, the Bad Debt appears as a ” Bad Debt Reserve” or ” Allowance for Doubtful Accounts” or as ” Provision for Bad Debts” and appears in the Liabilities section of the Balance Sheet.

Final Words

Bad Debt is an Operating Expense in the normal course of business. It is best to consult your Tax Advisor while preparing your Tax and Income Statement. Managing your tax liability and preparation of your Financial Statements is the job of professionals and it is advised that you consult a Public Accountant or a Tax Consultant while preparing your financial statements and filing your tax returns.

Also, check what type of account is allowance for doubtful accounts.