Bad debt is an expense incurred by a firm when a consumer’s credit repayment previously granted to them is deemed to be uncollectible and hence recorded as a charge off. Bad debt is a risk to which all companies that give credit to clients must account because there is always a chance that payment will not be made.
To identify bad debt expenses, there are two ways available. Accounts are written off using the direct write-off method when they are directly determined as uncollectible. In the U. S., this method is used for income tax purposes. While the direct write-off method records the actual amount for accounts that have already been assessed to be uncollectible, it does not follow the accrual accounting matching principle or generally accepted accounting principles (GAAP).
According to the matching principle, expenses must be matched to corresponding revenues in the very same accounting cycle as the revenue transaction. As a result, bad debt expense must always be calculated using the allowance method in the same period as the credit sale and reported on the income statement under the sales and general administrative expense category.
A debit entry to a bad debt expense is produced, as well as an offsetting credit entry to a counter asset account, also known as the allowance for doubtful accounts, is created when documenting projected bad debts. The allowance for doubtful accounts reduces the total accounts receivable on the balance sheet only to indicate the amount that is expected to be collected. This allowance grows throughout accounting periods and can be adjusted depending on the account balance.