John Foxx/Stockbyte/Getty Images
Cash basis accounting records transactions when cash and cash equivalents change hands, while accrual basis accounting records transactions at the time they occur, so long as certain conditions are met. Bad debt expense is the cost that a business incurs when a sum owed to it becomes uncollectible, and is recognizable only under accrual and other accounting bases that permit recording of unpaid revenues on accounts. In contrast, bad debt expense does not exist under cash basis.
Accrual basis accounting permits recording unpaid revenues as accounts receivable, so long as those revenues are earned and realizable. Earned means that the source transaction is complete, while realizable means that there is no reason to suspect that the cash cannot be collected. Despite these precautions, unpaid revenues can and do become uncollectible, resulting in bad debt expense.
Bad Debt Expense
Bad debt expense is accounted for using either the direct write-off or the allowance method. The direct write-off method records uncollectible accounts as bad debt expense when those accounts are deemed uncollectible, while the allowance method is a more proactive approach that estimates the uncollectible portion of accounts receivable in each period and records bad debt expense to adjust the estimate. Depending on the method, reducing bad debt expense involves either fewer debtors defaulting on their debts, or smaller estimates of the portion of uncollectible accounts receivable.
Reducing Bad Debt Expense
Reducing bad debt expense under the direct write-off method entails decreasing the number of defaults, as well as defaulting debtors owing smaller debts. Businesses can accomplish these aims through restricting their clientele to customers with greater liquidity and offering more lenient terms to their debtors. In comparison, reducing bad debt expense under the allowance method involves smaller estimates of the uncollectible portion of accounts receivable. Because businesses tend to base such estimates on historical trends, reducing bad debt expense reduces estimates.
Eliminating Bad Debt Expense
Businesses can eliminate bad debt expense by using cash basis accounting rather than accrual basis accounting. Cash basis accounting does not permit recording unpaid revenues on accounts.. Businesses do not record debt as revenue or at all until they collect cash. Because cash basis accounting is much less accurate, it is less useful than its accrual counterpart, and is not a good solution to the problem of high bad debt expense.
Alan Li started writing in 2008 and has seen his work published in newsletters written for the Cecil Street Community Centre in Toronto. He is a graduate of the finance program at the University of Toronto with a Bachelor of Commerce and has additional accreditation from the Canadian Securities Institute.