What is bad debt expense and how do you calculate it?
Bad debt expense — what it is, how to calculate it, and what it tells you about your AR
Short answer
Bad debt expense is the portion of your accounts receivable that accounting standards require you to recognize as unlikely to be collected — even before you actually write off a specific invoice. Under GAAP's matching principle, bad debt expense is recorded in the same period as the revenue, not when you finally give up on collecting. The two standard methods: percentage of sales (estimate bad debt as a fixed percentage of credit sales each period) and the aging method (apply different loss rates to different aging buckets — 1% on 0–30 days past due, 5% on 31–60 days, 25% on 61–90 days, 50% on 90+ days). The aging method is more accurate and preferred by most accountants.
Bad debt expense is a cost of doing business on credit terms. Every business that invoices customers and waits for payment accepts some probability that a fraction of invoices will not be collected. Accounting standards (GAAP and IFRS) require that this expected loss be recognized as an expense in the same period the revenue was earned — not when the specific invoice is eventually written off. This is the matching principle in action.
The percentage-of-sales method is simpler. If your historical data shows that roughly 2% of credit sales become uncollectable, you record bad debt expense as 2% of each period's credit sales, regardless of which specific invoices eventually go bad. This is easy to apply and smooths the expense over time, but it can lag when your client mix or payment behavior changes significantly.
The aging method is more precise and more defensible in an audit. You apply different loss rates to different buckets of your AR aging report: a small percentage on current and recently-due invoices (low loss expectation), a higher percentage on invoices 31–90 days past due (moderate loss expectation), and a high percentage on invoices over 90 days past due (most will not be collected at full face value). The rates are derived from your own historical data or industry benchmarks. The sum of those expected losses becomes your bad debt expense for the period.
The allowance for doubtful accounts (ADA) is the balance sheet counterpart. When you record bad debt expense, the offsetting credit goes to the ADA — a contra-asset account that reduces the net realizable value of your AR. The ADA is a running reserve, not a write-off; it says 'we expect $X of our total AR balance will not be collected.' When you actually write off a specific invoice, it reduces both the ADA and the AR balance — no income statement impact at that point because the expense was already recognized.
Why this matters operationally: a rising bad debt expense percentage is an early warning signal. If you start to see ADA growing faster than revenue, your client mix is getting riskier, your collections are slowing, or both. Tracking this number quarterly gives you visibility into AR quality before the write-offs accumulate. The best outcome is a bad debt expense that is consistently low — which means your follow-up process is catching invoices early, before they migrate into the high-loss aging buckets.