Bad debt expense is considered an estimate because it’s a way of acknowledging that not all customers will pay their bills on time, and some may not pay at all.
This estimation is crucial because it deals with the unpredictable nature of customer payments.
To tackle this uncertainty, companies adhere to accounting rules like GAAP and IFRS, recognizing bad debt expense as an estimated figure.
More Reasons Bad Debt Expense is an Estimate
|Unpredictable Payments||Companies can’t predict which customers won’t pay on time or at all when selling on credit.|
|Matching Principle||Expenses should be recorded in the same period as related revenue. Estimating bad debt aligns with this principle.|
|Being Cautious||Conservative accounting ensures that profits aren’t overstated, so careful estimation of bad debt is essential.|
|Accrual Accounting||Accrual accounting records events when they occur, not when money changes hands, providing a more accurate view.|
To estimate bad debt expense, companies use one of two methods:
- Percentage of Sales Method: This is like saying, “Based on past experience, we think a certain percentage of the money we earned from sales won’t get paid.”
- Aging of Accounts Receivable Method: Here, we divide the money owed to us into categories based on how long it’s been owed. The longer it’s owed, the more likely it might not get paid. So, we use different estimates for each category.
This estimated bad debt expense goes on the income statement as an expense, and a special account called the “allowance for doubtful accounts” is set up on the balance sheet.
This account reduces the value of accounts receivable (the money customers owe), reflecting that not all of it may be collected.