Determining and writing off bad debts is an inevitable part of running a business that offers credit to customers. While unpleasant, properly accounting for bad debts is crucial for accurate financial reporting and tax compliance. In this comprehensive guide we’ll walk through the key steps involved in identifying calculating, and recording bad debt write-offs.
What Constitutes a Bad Debt?
Before diving into the write-off process, it’s important to understand what constitutes a bad debt. A bad debt refers to an accounts receivable balance that is deemed uncollectible due to the customer’s inability or unwillingness to pay. Common reasons a debt may be categorized as “bad” include:
- The customer has gone bankrupt.
- The customer has repeatedly ignored requests for payment.
- The cost of pursuing legal action exceeds the amount owed.
- The debt is significantly past due (often over 90 days).
The likelihood of payment must be thoroughly assessed to determine whether further collection efforts are viable or if write-off is necessary.
Calculating Bad Debt Write-Offs
Once a debt is officially marked as “bad,” it’s easy to figure out how much to write off. Here are the two most common methods .
1. Direct Write-Off Method
This involves simply writing off the specific, identified uncollectible amount. For example, if a customer owes $1,000 that you determine is uncollectible you would write off the full $1,000.
2. Percentage of Receivables Method
This method lets you guess how much money you still owe based on a percentage of your total receivables. Here’s an example: If you think that 5% of your accounts receivable will turn into bad debts, you would write off that amount.
The percentage can be calculated based on past trends and industry benchmarks. Percentages typically range from 1% to 10%.
Recording Bad Debt Write-Offs
Once the amount is calculated, proper accounting treatment is essential. Here are the steps to record a write-off:
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Debit the Bad Debt Expense account for the receivable amount. This records the loss on the income statement.
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Credit the Accounts Receivable account for the same amount. This removes the amount from receivables.
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Review sales tax impacts. You may need to deduct sales tax originally charged if the debt is now uncollectible.
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Provide thorough documentation explaining the rationale for write-off.
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Adjust records accordingly, including aging reports, ledgers, and financial statements.
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Note the write-off in communications with the customer.
Tax Considerations
Bad debt write-offs also have tax implications that must be handled properly:
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The write-off is deductible for tax purposes in the year it occurs.
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Only physical cash-basis taxpayers can take the deduction. Accrual-basis taxpayers must deduct the allowance account.
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The debt must be wholly or partially worthless to qualify for deduction.
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Proper documentation should be maintained to support the write-off in case of an IRS audit.
Alternatives to Write-Off
While write-off is appropriate for many uncollectible debts, other options exist that may be preferable in some circumstances:
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Debt restructuring – Work with the customer to modify payment terms or refinance the debt so collection remains possible.
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Settlement negotiations – Agree to reduced payment from customer to satisfy debt. May recover more than write-off.
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Sale of debt – Sell debt to third party collector at a discount, removing burden of collection.
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Legal action – Pursue payment through the court system if amount warrants the legal costs.
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Collection agency – Hire agency to recover debt professionally, especially for large balances.
Preventing Bad Debts
To reduce bad debt losses, focus on prevention by:
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Implementing robust credit approval processes to assess customer risk levels.
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Carefully crafting credit terms for higher-risk customers.
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Diligently following up on past due accounts.
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Leveraging collections automation tools to streamline processes.
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Continuously refining credit policies based on past write-off trends and causes.
Key Takeaways
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Bad debts must be accurately calculated and recorded to reflect economic reality.
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Direct write-off or percentage of receivables are common calculation methods.
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Follow proper accounting treatment, including adjusting accounts impacted.
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Tax deductions may be available, but documentation is key.
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Consider all alternatives before simply writing off a debt.
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Ongoing prevention activities will reduce write-offs long-term.
While bad debt write-offs reduce profitability, a sound process for identifying, recording, and learning from them can help minimize losses and improve future decision making.
How Do You Record Bad Debt Expense?
Under the allowance method of calculating bad debts, there are two general ledger accounts – bad debts, an expense account, and allowance for doubtful accounts, a contra-asset account used to offset the accounts receivable balance.
To record the bad debt expenses, you must debit bad debt expenses and a credit allowance for doubtful accounts.
| Date | Accounts | Reference | Debit | Credit |
| 31-Jun-24 | Bad Debt Expense | $170 | ||
| Allowance for Doubtful Accounts | $170 | |||
| 02-Jul-24 | Allowance for Doubtful Accounts | $170 | ||
| Accounts Receivables | $170 |
With the write-off method, there is no contra-asset account to record bad debt expenses. Therefore, the entire balance in accounts receivable will be reported as a current asset on the balance sheet. This entails a credit to the Accounts Receivable for the amount that is written off and a debit to the bad debts expense account.
| Date | Accounts | Reference | Debit | Credit |
| 31-Jun-24 | Bad Debt Expense | $170 | ||
| Accounts Receivable | $170 |
Each time the business prepares its financial statements, bad debt expenses must be recorded and accounted for. Failing to do so means that the assets and net income may be overstated.
Identifying and calculating bad debt expense also helps identify customers that default on payments more often than others. Businesses can use this to identify customers that are creditworthy and offer them discounts for their timely payments.
What Is Bad Debt Expense?
Allowance for bad debts is a contra-asset account, where a business records an estimated amount of receivables that they don’t expect to collect from customers. On the balance sheet, the allowance offsets the number of outstanding accounts receivable (which is then presented at their net realizable value).
The journal entry to record an estimate for bad debts is to debit a bad debt expense account and credit allowance for uncollectible accounts.
You’re only required to record bad debt expenses if you use the accrual accounting method since this method recognizes credit sales as income when earned. If you use the cash accounting method, you record income and expenses when cash is received or spent.
Accounting for Bad Debts (Journal Entries) – Direct Write-off vs. Allowance
FAQ
How to calculate bad debt written off?
Direct write-off method. In this technique, the bad debt is directly considered as an expense, and the debt ratio is calculated by dividing the uncollectible amount by the total Accounts Receivables for that year.
What qualifies as a bad debt write-off?
The unpaid debt must be 100% worthless before you can deduct it. There must be no chance that the borrower can or will ever pay you back the amount of the loan. May 12, 2025.
What is the formula for calculating bad debt?
Here’s the basic formula for estimating bad debt via the percentage of receivables method: Bad debt expense = Percentage receivables estimated uncollectible * Receivables balance.
How do you determine the amount of bad debts expense?
There are two ways to figure out bad debt expense: the direct write-off method and the allowance method. The direct write-off method charges the invoice amount directly to bad debt expense and takes it away from accounts receivable. This method is only used for federal income tax purposes.