How Bad Debt Expense Impacts the Income Statement

Bad debt expense represents the cost of uncollectible accounts receivable that a company estimates or identifies during a reporting period. It reflects the economic reality that not all customers will fulfill their payment obligations. Recognizing bad debt expense ensures that revenues and related costs are matched in the same period, maintaining the integrity of accrual accounting and providing a realistic view of net income.

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How bad debt expense arises

Bad debt expense arises when a company determines that certain customer balances are unlikely to be collected, either due to financial distress, disputes, or insolvency. Under modern accounting standards, this expense is typically estimated proactively using expected credit loss models rather than waiting for actual defaults.

Example:If a company records 1,000,000 in credit sales and estimates that 3 percent of receivables may become uncollectible, it recognizes a bad debt expense of 30,000 during the same period. This aligns the recognition of expense with the revenue that generated those receivables.

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Presentation in the income statement

Bad debt expense is classified within selling, general, and administrative expenses (SG&A) or under operating expenses in the income statement, depending on the reporting format.

Example:

Item	Amount (USD)
Revenue	1,000,000
Cost of Goods Sold	(600,000)
Gross Profit	400,000
Selling and Administrative Expenses	(150,000)
Bad Debt Expense	(30,000)
Operating Income	220,000

This presentation ensures that credit losses are treated as an ordinary operating cost of extending credit to customers.

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Journal entries for bad debt expense

To record estimated bad debts:

• Debit: Bad Debt Expense 30,000

• Credit: Allowance for Doubtful Accounts 30,000

To write off a specific uncollectible account:

• Debit: Allowance for Doubtful Accounts 5,000

• Credit: Accounts Receivable 5,000

If a previously written-off amount is recovered:

• Debit: Accounts Receivable 5,000

• Credit: Allowance for Doubtful Accounts 5,000

• Debit: Cash 5,000

• Credit: Accounts Receivable 5,000

This process ensures the expense is matched appropriately and the receivable balance reflects collectibility.

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Standards under IFRS and US GAAP

• IFRS 9 (Financial Instruments): Requires recognition of expected credit losses (ECL) using a forward-looking approach, updating estimates each period based on risk exposure and economic forecasts.

• US GAAP (ASC 326 – CECL): Similar concept, requiring immediate recognition of lifetime expected losses when receivables are originated or acquired.

Both frameworks emphasize early recognition and regular reassessment of credit loss allowances, making bad debt expense more dynamic and responsive to changing risk environments.

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Impact on financial performance and ratios

Bad debt expense reduces operating income and net profit, directly affecting performance metrics such as return on assets (ROA) and profit margin. A rising bad debt expense can indicate either increased sales on credit or deteriorating customer payment behavior.

For instance, if net income declines from 250,000 to 220,000 primarily due to a rise in bad debt expense, analysts will investigate whether this stems from expanding credit risk or an adjustment in estimation policy.

Credit quality trends are often analyzed using the ratio:

Bad Debt Expense / Net Sales,where a stable ratio indicates consistent credit management, and volatility signals risk or aggressive revenue policies.

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Disclosures required for bad debt expense

Companies must disclose:

• The accounting policy for recognizing credit losses.

• Movements in the allowance for doubtful accounts.

• Significant assumptions used in estimating uncollectible amounts.

• Changes in credit risk or economic conditions that affect the estimate.

These disclosures help users assess how conservative or aggressive management’s estimates are and how they impact the reliability of earnings.

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Operational considerations

Bad debt expense links accounting estimation to operational decision-making. Strong internal controls over credit approval, monitoring, and collection minimize the need for large write-offs. Conversely, lenient credit policies or weak collection procedures often lead to higher bad debt expense and cash flow strain.

For management, the key challenge is maintaining competitive sales growth while controlling credit exposure. For analysts and investors, consistent recognition policies signal stable earnings quality and disciplined financial management.

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