What is a bad debt expense and how to protect your business

When a customer defaults on its bills or is in danger of doing so, the company extending credit to that customer faces a bad debt expense. Bad debt expense reflects the amount of
accounts receivable that a company is unable to collect now and may not be able to collect in the future. Because this bad debt expense must be charged against the company's accounts receivable, it reduces the amount of accounts receivable on the company’s income statement.

How do you calculate bad debt expense in an accounts receivable?

Bad debt is often measured as a percentage of accounts receivable. To calculate this percentage, divide the total amount of bad debt by the total accounts receivable and multiply the result by 100.

For example, a company with £1 million in accounts receivable and £50,000 in bad debt would calculate:

£50,000 ÷ £1,000,000 = 0.05

0.05 × 100 = 5%

In this example, bad debt represents 5% of the company's accounts receivable balance.

While bad debt expense reflects actual or expected losses from unpaid invoices, a bad debt provision helps businesses recognise those potential losses before they occur.

What is a bad debt provision and where does it go on a P&L?

A bad debt provision is the amount you set aside in your accounts to cover receivables you don't expect to collect in full. Rather than waiting until an invoice is confirmed as unrecoverable, you estimate the likely loss in advance and record it against your profit for that period.

Creating a provision for bad debts starts with a journal entry that debits bad debt expense and credits the allowance for doubtful debts (or bad debt provision) account. This contra-asset account reduces the net value of accounts receivable on the balance sheet, helping businesses estimate the amount they realistically expect to collect.

How do you calculate a bad debt provision?

To work out the amount of a bad debt provision, many businesses apply specific percentages to their total sales or receivables, based on historical data about how much has gone unpaid in previous years. Take the following example:

A business has £80,000 in outstanding invoices and historical data shows that approximately 3% of receivables become uncollectable.

Bad debt provision = Accounts receivable × Estimated bad debt rate

£80,000 × 3%

= £2,400

The business would therefore create a bad debt provision of £2,400 by debiting bad debt expense and crediting the allowance for doubtful debts account.

The provision should be reviewed and updated regularly as customer circumstances change, helping ensure your accounts reflect the most accurate estimate of potential losses.

How do you create provisions for doubtful debts?

Provisions for doubtful debts generally fall into two categories: a general provision, based on historical write-off rates across your whole receivables book, and a specific provision, applied to individual customers you believe are unlikely to pay.

Some businesses refine their general provision using an aging of receivables approach. This means splitting your accounts into brackets, such as current, 30-60 days overdue, and 90 days plus, then applying a higher percentage to older debts, since they're statistically less likely to be collected.

There are two main methods for accounting for bad debt expense: the direct write-off method and the allowance method. Of the two, the allowance method is generally preferred because it provides a more accurate picture of a company's financial position.

1. Write-off method for bad debt expense

When reporting bad debts expense, a company can use the direct write-off method or the allowance method. The direct write-off method reports the bad debt on an organisation’s income statement when the non-paying customer’s account is actually written off, sometimes months after the credit transaction took place. The accountant then records the loss by debiting bad debts expense and crediting accounts receivable.

Under the direct write-off method, accounts receivable may be overstated because uncollectible debts are not recognised until a specific customer defaults. This can result in financial statements that do not accurately reflect the amount a business expects to collect. Instead, accountants typically apply the allowance method.

2. Allowance method for bad debt expense

Using the allowance method, accountants record adjusting entries at the end of each period based on anticipated losses. At the end of each year, companies review their accounts receivable and estimate what they will not be able to collect. Accountants debit bad debts expense and credit it a contra-asset account known as the allowance for doubtful accounts.

When accountants ultimately write off an accounts receivable as uncollectible, they can then debit allowance for doubtful accounts and credit that amount to accounts receivable. Using this method allows the bad debts expense to be recorded closer to the actual transaction time and results in the company’s balance sheet reporting a realistic net amount of accounts receivable.

What is an allowance for doubtful accounts?

The allowance for doubtful accounts sits on your balance sheet just below accounts receivable, reducing that figure down to what you realistically expect to collect.

This account also protects your income statement from sudden shocks. Rather than absorbing one large loss when a customer finally defaults, you spread the estimated cost across the periods where the related sales were made, helping match potential losses to the period in which the related sales were made and providing a more accurate view of profitability.

Bad debts are not good for a business. While one or two bad debts of small amounts may not make much of an impact, large debts or several unpaid accounts may lead to significant loss and even increase a company’s risk of bankruptcy. Bad debts also make your company’s accounting processes more complicated and, in addition to monetary losses, take up valuable staff time and resources as they unsuccessfully try to collect on the debts.
Try our free Cover the Loss Calculator to see how much you'd have to make in additional sales to make up for a single customer default: 
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Bad debt protection is designed to help businesses recover some of their losses when a customer becomes insolvent and is unable to pay outstanding invoices. For companies that regularly offer credit terms, it can provide valuable financial support when a customer's financial difficulties result in non-payment.

However, bad debt protection typically focuses on losses caused by customer insolvency. This means it may not cover situations where a customer remains solvent but delays payment, disputes an invoice or simply fails to pay.

How to protect your business from bad debt

While no business can eliminate bad debt entirely, there are several steps that can help reduce the risk and minimise potential losses.

Many businesses strengthen their credit management processes by setting customer credit limits, monitoring outstanding invoices and reviewing customer creditworthiness on a regular basis. Companies may also apply stricter payment terms for higher-risk customers or require advance payment, a letter of credit or other payment security before supplying goods or services.

Credit policies can also be adjusted in response to changing market conditions. For example, if businesses within a particular sector or region are experiencing financial difficulties, suppliers may choose to reduce credit exposure or introduce tighter lending criteria until conditions improve.

What are the benefits of bad debt protection?

Bad debt protection can help businesses reduce the financial impact of customer insolvencies and protect cash flow from unexpected losses. By providing compensation for unpaid invoices in certain circumstances, it can offer reassurance when extending credit to customers.

However, because customer non-payment can occur for reasons other than insolvency, bad debt protection may not provide sufficient cover for every business.

What's the difference between trade credit insurance and bad debt protection?

For many businesses, trade credit insurance offers broader protection than traditional bad debt protection. Rather than covering insolvency alone, trade credit insurance can protect against a wider range of customer non-payment risks, helping businesses trade with greater confidence.

In addition to covering insured losses, trade credit insurance provides access to credit intelligence, risk monitoring and expert support that can help businesses make better credit decisions and reduce the likelihood of bad debt occurring in the first place.

While bad debt protection generally covers losses arising from customer insolvency, trade credit insurance can also cover protracted default, where a customer remains solvent but fails to pay within an agreed period.

Depending on the policy, trade credit insurance may also provide protection against:

• Customer insolvency
  
• Protracted non-payment
  
• Political risks affecting international trade
  
• Certain export-related risks
  
• Pre-shipment risks for bespoke goods that cannot easily be resold
  
• Other trade-related risks, depending on the scope of cover
  

By combining risk prevention, ongoing monitoring and financial protection, trade credit insurance helps businesses safeguard cash flow, protect profits and trade with greater confidence.

Although bad debt expense can have a significant impact on cash flow and profitability, businesses can take steps to reduce their exposure to customer non-payment. Trade credit insurance helps protect against bad debt-related losses, while also providing access to customer credit insights, ongoing risk monitoring and expert support to help businesses make more informed credit decisions.

As the world's leading trade credit insurer, Allianz Trade supports over 75,000 businesses worldwide with risk intelligence, credit management expertise and tailored trade credit insurance solutions. By combining prevention with protection, trade credit insurance helps businesses minimise losses, protect cash flow and trade with greater confidence, even in uncertain economic conditions.