How to calculate bad debt expense

We know collecting payments from customers isn't always straightforward. Sometimes, despite your best efforts, invoices go unpaid — and that's where bad debt expense comes into play. In this article, you’ll learn how to calculate bad debt expense for your small business.

What is bad debt expense?

Bad debt starts with an unpaid invoice. Maybe you provided services to a customer who later went bankrupt, or perhaps you've been trying to collect payment for months with no success. When you realize you won't be able to collect that money, it becomes a bad debt.

Bad debt expense is how we record these unpaid amounts in your books. Let's say you run a small consulting firm and completed a $5,000 project for a client. You sent the invoice, but the client's business closed unexpectedly. That $5,000 you'll never collect? That's your bad debt expense.

How to calculate bad debt expense:

There are two main ways to handle bad debt in your books — the direct write-off method and the allowance method. Let's look at both.

The direct write-off method

This is the simpler approach — you record the bad debt expense when you're certain you won't collect the payment. Going back to our consulting example, you'd write off that $5,000 as bad debt expense when you learn the client's business has closed.

While this method is straightforward, it has a significant drawback — it doesn't comply with Generally Accepted Accounting Principles (GAAP). Why? Because it records the expense in a different period from when you earned the revenue, which violates the matching principle.

The allowance method

This is the GAAP-compliant way to handle bad debts. Instead of waiting until you know for sure that you won't collect, you estimate your bad debts in advance. There are two ways to calculate this estimate.

Percentage of sales approach

With this method, we estimate bad debt based on your past experience with uncollectible amounts. Let's say your historical data shows that about 2% of your credit sales typically go unpaid. If you have $200,000 in credit sales this year, you'd estimate your bad debt expense at $4,000 (2% of $200,000).

The percentage of sales approach works best when your sales volume is relatively stable and you have a consistent history of bad debts. It's particularly useful for businesses with a large number of small accounts, like retail stores or subscription services, where individual customer default rates are fairly predictable.

Percentage of accounts receivable approach

This method looks at your current accounts receivable balance and estimates what percentage might go unpaid. For example, if you have $100,000 in accounts receivable and expect 3% to be uncollectible based on past experience, you'd record an estimated bad debt expense of $3,000.

The accounts receivable approach is often more accurate for businesses with fewer, larger accounts or those with varying payment terms. It's especially useful if you're in an industry where economic conditions significantly impact collection rates, like construction or business consulting. This method also helps when your sales fluctuate seasonally, as it's based on your actual outstanding balances rather than sales volume.

What to do if you're worried about bad debt expenses

If bad debt is becoming a concern for your business, we've got good news — there are several ways to get ahead of the problem. Modern accounting software can help you track payment patterns and flag potential issues early. These tools can show you which customers consistently pay late or have unpaid balances, helping you make informed decisions about extending credit.

But software is just the start. Working with a financial professional can make a huge difference. A good accountant can help you set up proper credit policies, implement effective collection procedures, and maintain accurate records of your accounts receivable. Plus, they’ll make sure you're using the right method to calculate and record bad debt expenses for your business size and industry.

Ready to get started?

Managing bad debt is just one piece of the small business accounting puzzle. From setting up your books to tax planning strategies, we're here to help you build a stronger financial foundation for your business.

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