How a Bad Debt Write-Off Affects Your Profit and Loss
Properly managing uncollectible accounts is crucial for accurate financial reporting. See how the process impacts your net income and balance sheet.
A bad debt write-off is an accounting measure that removes an uncollectible receivable from the books. This action treats the unpaid amount as an expense, impacting a company’s financial statements. By recognizing that a debt will not be paid, a business ensures its assets are not overstated and that expenses are properly matched with revenues.
Identifying and Valuing Uncollectible Accounts
A business must first determine an account is uncollectible before writing it off. This decision is often triggered by a customer’s bankruptcy, an admission of inability to pay, or a failure to make contact after numerous attempts.
The primary method for valuing these accounts, preferred under Generally Accepted Accounting Principles (GAAP), is the allowance method. It estimates future bad debts and records them in a contra-asset account called “Allowance for Doubtful Accounts.” This allowance reduces total accounts receivable to its net realizable value and aligns the expense with the period of the related sale.
One way to estimate the allowance is the percentage of sales method, which applies a historical percentage to a period’s credit sales. For instance, if a company finds 0.5% of credit sales are historically uncollectible and has $200,000 in credit sales, it would record a $1,000 bad debt expense.
A more detailed approach is the aging of accounts receivable method. This technique categorizes receivables by how long they are past due, such as 0-30 days or 31-60 days. Older debts are assigned a higher percentage of expected uncollectibility to calculate the required balance for the allowance account.
In contrast, the direct write-off method records bad debt expense only when a specific account is deemed uncollectible. This method is not compliant with GAAP because it fails to match expenses with revenues in the same period.
The Accounting Process for Writing Off Bad Debt
When an account is deemed uncollectible, the business records the write-off. The accounting entries depend on whether the company uses the allowance or direct write-off method, each impacting the financial statements differently.
Under the allowance method, the journal entry to write off a bad debt is a debit to “Allowance for Doubtful Accounts” and a credit to “Accounts Receivable.” This action does not affect the net realizable value of accounts receivable, as the reduction in the asset is offset by the reduction in the contra-asset.
With the allowance method, there is no immediate impact on the profit and loss statement during the write-off. The expense was already recognized when the allowance was created. The write-off simply confirms a previously estimated loss.
The direct write-off method directly impacts the profit and loss statement. Its journal entry debits “Bad Debt Expense” and credits “Accounts Receivable.” This removes the receivable and recognizes the full loss as an expense in the current period.
Tax Deduction Rules for Bad Debt
Deducting bad debt for taxes is governed by IRS rules that differ from accounting practices. To claim a deduction, a business must prove a debtor-creditor relationship existed. The income from the receivable must also have been included in taxable income, which is standard for businesses using accrual accounting.
A debt must be wholly or partially worthless to be deductible, and the business must have taken reasonable steps to collect it. Evidence includes records of collection letters and correspondence. While a debtor’s bankruptcy is a strong indicator, the taxpayer must show that legal action to collect would likely fail.
Tax treatment depends on if the debt is a business or nonbusiness bad debt. A business bad debt arises from operating a trade or business and is deductible as an ordinary loss against other income. A business can also deduct a partially worthless bad debt.
A nonbusiness bad debt, like a personal loan, has less favorable tax treatment. It must be completely worthless to be deductible, as no deduction is allowed for partial worthlessness. It is treated as a short-term capital loss, used first to offset capital gains and then up to $3,000 of ordinary income annually.
Accounting for Recovered Bad Debt
When a business receives payment for a debt previously written off, it is a bad debt recovery. This event requires specific accounting entries to correct the financial records.
Accounting for a recovery is a two-step process. First, the original accounts receivable is reinstated by reversing the write-off entry. With the allowance method, the entry is a debit to “Accounts Receivable” and a credit to “Allowance for Doubtful Accounts.” If using the direct write-off method, the credit is to “Bad Debt Expense” or a “Bad Debt Recovery” account.
Second, the cash payment is recorded with a standard entry: a debit to “Cash” and a credit to “Accounts Receivable.” This clears the reinstated receivable and increases the company’s cash.
For tax purposes, a bad debt recovery is taxable income in the year received. The IRS requires including the recovered amount in gross income to the extent the original write-off provided a tax benefit. For example, if a $1,000 bad debt was deducted and $600 was later recovered, the $600 is reported as income.