Are you running a small business and experiencing problems with bad debt? You may not be able to make bad debt expenses disappear, but you can minimize the damage by understanding how to calculate bad debt expenses.
There are different methods to calculate bad debt expense, and you can choose the one that works best for you. And if bad debt expense has a silver lining, it will reduce your income tax liability.
This blog is all about How to Calculate Bad Debt Expenses?
What Is A Bad Debt Expense?
Bad debt expense becomes a problem when you make sales based on any type of credit. This can include credit card sales or accounts receivable when you offer delayed payment terms to your customers. Bad debt occurs when some of those sales go unpaid, even though you’ve already provided the product or service.
Because you will have already included the sales in your records, the bad debt expenses will reduce your income after the fact.
(Bad debt expense is rarely an issue with cash sales since payment is immediate.)
Calculating bad debt expense is important to reduce your net business income. When you do, your taxable income declines, so you’ll owe less in income tax.
How To Calculate Bad Debt Expense?
There are different methods to calculate bad debt expense, and you can choose the one that works best for you and your business.
The main focus will be accounts receivable since that’s an arrangement where you’re offering credit to your customers to incentivize them to buy from you.
But it’s also possible with credit card sales, even though that’s less common. For example, a customer can insist on a refund – sometimes through the credit card issuer – for what they believe to be poor service or inferior merchandise. Either way, you’ll lose the sale, but you’ll be unlikely to get back the product or service for future resale.
But whether the bad debt is the result of accounts receivable or credit card sales, you can use any of the three methods below to calculate them:
1. Direct Write-Off Method
This is the simplest method. You’ll keep track of bad debts, total them up at the end of the year, and use them to reduce your gross business income when you file your income tax return.
You can deduct bad debt expense against your income on IRS Form Schedule C under the income section on Line 2, Returns and allowances (“allowances” is short for “allowance for bad debt” ):
In addition to the direct write-off method, you can use a couple of methods to estimate your bad debt expense in advance.
2. Percentage Of Bad Debt
You can reasonably estimate bad debt expense for the current year by calculating the percentage of credit sales that have turned into bad debt in previous years.
For example, you might decide to estimate the percentage of the bad debt based on the results from the last three years like this:
| Year | Bad Debt Expense | Total Credit Sales | Percentage of Bad Debt |
| 2020 | $2,000 | $50,000 | 4% |
| 2021 | $2,250 | $75,000 | 3% |
| 2022 | $3,500 | $100,000 | 3.5% |
| Totals | $7,750 | $225,000 | 3.44% |
Based on your bad debt experience for the previous three years, you can estimate the percentage of bad debt for 2023 at 3.44%. It may not be the exact percentage at the end of the year, but it will probably come pretty close.
3. Accounts Receivable Aging Method
If you’re offering credit through accounts receivable, you should maintain an accurate accounts receivable aging schedule.
These are common features of business bookkeeping software like QuickBooks and Bonsai.
You should have one and be regularly updated, regardless of your bad debt expense method.
An accounts receivable aging schedule looks like this:
| Customer | <30 Days Late | 31 – 60 Days Late | 61 – 90 Days Late | >90 Days Late |
| Smith | $1,500 | $500 | $0 | $0 |
| Jones | $0 | $700 | $400 | $0 |
| Williams | $0 | $0 | $300 | $1,200 |
| Totals | $1,500 | $1,200 | $700 | $1,200 |
An up-to-date accounts receivable aging schedule will give you immediate access to the status of your accounts receivable at any time. Or, more specifically, the accounts that are more than 30 days late.
By maintaining an accounts receivable aging schedule and regularly tracking accounts that go completely unpaid, you can reasonably estimate what percentage of your past-due accounts are likely to become bad debts.
This can easily be tracked using a summary accounts receivable aging report that will summarize the status of your accounts receivable at any point in time. Based on experience, you can use an alarming debt expense percentage to estimate how much bad debt is likely to happen based on how long the receivables are outstanding:-
| <30 Days Late | 31 – 60 Days Late | 61 – 90 Days Late | >90 Days Late | Totals | |
| Total Receivables | $30,000 | $20,000 | $10,000 | $5,000 | $65,000 |
| Bad Debt % | 2% | 4% | 15% | 25% | – |
| Bad Debt Estimate | $600 | $800 | $1,500 | $1,250 | $4,150 |
The schedule above is a summary version of the accounts receivable aging schedule that lists individual accounts. This one summarizes all receivable accounts and provides a bad debt estimate of $4,150.
What Happens If The Amount Of Bad Debt Expense Is Overstated At Year End?
There may be times when your bad debt expense is overstated. That can happen when an account is written off as bad debt and makes a payment well after the fact.
If the payment is received in the year when the sale was made, you can simply reduce your bad debt expense before filing your income tax return.
But it gets more complicated if the written-off account is paid after the year ends.
Most small businesses operate on what’s known in the accounting world as a “cash basis.” That means income and expenses are recognized in the year they happen. In that case, a sale made in 2022, but paid in 2023, is recognized as income in 2023 – not 2022.
The same is true of expenses. An expense incurred in 2022 but paid in 2023 will be recognized for 2023.
But if you’re using a bad debt expense allowance method (percentage of bad debt or accounts receivable aging), and a bad debt is paid after year-end, you’ll need to adjust the expense.
If you haven’t yet filed your income tax return, you can simply lower the bad debt expense allowance by the amount of the payment received.
But if the payment amount received after your taxes have been filed is small, you may be able to reduce your bad debt expense for the current year. However, if it’s a large amount that will impact your tax liability, you may need to file an amended tax return. If so, you should consult a tax advisor to help you fix the problem.
If you prepare your own return, most tax software provides the ability to amend your return easily.
How To Lower Bad Debt Expense?
If you are experiencing bad debt expenses in your business, understand that it is not your fault. Bad debt is an inevitable result of making credit sales, which is necessary to generate more sales.
Here are steps you can take to minimize how much bad debt you’ll have:
1. Offer multiple payment options, like credit cards, debit cards, PayPal, and any others that will work in your business.
2. Maintain an up-to-date accounts receivable aging schedule, paying close attention to customers who regularly pay late.
3. Set a credit cut-off date after which you will no longer extend credit to delinquent customers. For example, once customers go beyond 30- or 60-days late, they should no longer be eligible for additional credit.
4. Send regular reminders to your credit customers. Reminders sent by email will be the least expensive method.
5. Offer a small discount to credit customers to incentivize them to pay upfront.
6. If a customer is seriously late (beyond 90 days), offer a reduced settlement. It’s better to get at least some money out of a customer than to lose the entire amount.
You probably can’t make the bad debt go away completely, but you can reduce it to less damage.
Conclusion
If you’re a small business owner who sells on credit, calculating bad debt expenses is a necessary step to ensure that your business remains financially healthy. Failing to calculate bad debt expenses accurately could eat into your profits and result in overpaying your income taxes.
But with the help of small business accounting software like QuickBooks and the strategies outlined in this guide, you can simplify the process and clearly understand your business’s financial performance. This knowledge can inform your decision-making and help you make informed choices about your business’s future.
So don’t overlook the importance of calculating bad debt expense. By taking the time to do it right, you can make the most of your revenue and avoid potential financial pitfalls. Use this guide and QuickBooks to streamline the process and keep your business on track.
FAQs
This is an issue for accountants. But for most small businesses, bad debt expense will simply be reported as an expense on the profit and loss statement or as a reduction of gross income. Either way, it will reduce the business’s net profit, which will also lower your income tax liability.
As described above, you can use the actual bad debt expense (direct write-off method) or make an allowance based on past performance (percentage of bad debt or accounts receivable aging).
One example is a $500 account receivable that goes unpaid (using the direct write-off method). Another is where you have $100,000 in accounts receivable and expect 2.5% to go bad. In that case, your bad debt expense will be $2,500.
