Bad Debt Expense

Bad debt expense is the cost a business records for money it does not expect to collect. For a lender, that money is unpaid loan principal. Banks and credit unions usually call it the provision for credit losses. Others say bad debt expense or credit loss expense.

There are two ways to record it.

• Direct write-off method. The expense is recorded only when a specific debt is judged uncollectible. It is simple, but the loss shows up late. US generally accepted accounting principles (GAAP) do not allow it when losses are material.
• Allowance method. The lender estimates losses ahead of time and keeps a reserve, called the allowance. Under the current expected credit loss (CECL) standard, the allowance covers losses expected over the full life of the loans. The expense is whatever it takes to bring the allowance to the right size.

How to calculate it (allowance method). Expense equals the ending allowance you need, minus the allowance you started with, plus net charge-offs (write-offs minus recoveries) during the period.

Worked example. A loan fund starts the quarter with a $100,000 allowance. It charges off $30,000 of loans and recovers $5,000, so net charge-offs are $25,000. That leaves $75,000 in the allowance. Its updated estimate says it needs $110,000. Bad debt expense = $110,000 − $100,000 + $25,000 = $35,000.

Why it matters for lenders

Three terms get mixed up. The loan loss reserve, or allowance, is a balance on the balance sheet. Bad debt expense is the charge on the income statement that refills it. A charge-off is the act of writing a specific loan off, which uses up the allowance but does not itself create new expense under the allowance method.

The expense hits earnings directly, so a jump in expected losses can turn a profitable quarter into a loss. Boards, investors and examiners watch the expense, the allowance and charge-offs together to judge whether a lender is honest about its credit risk.

How it works in practice

A CDFI's controller closes the quarter. She pulls the loan list by pool, with balances, grades and days past due. She logs this quarter's two charge-offs and one recovery, then runs the CECL model to get the new allowance target. The difference, plus net charge-offs, becomes the provision entry in the general ledger.

Problems start when charge-offs are tracked in one spreadsheet, recoveries in another and balances in the servicing system. The numbers stop tying out. Recording each charge-off and recovery on the loan itself keeps the allowance math traceable.

This is general education, not accounting advice. Lenders should confirm their method with their accountant.