How to Calculate and Record Bad Debt Expense

Bad debt expense represents money owed that is unlikely to be collected. It impacts financial health and requires careful accounting. Understanding how to identify, record, and manage these uncollectible amounts is important for maintaining accurate financial records and making informed decisions.

Defining Bad Debt Expense

Bad debt expense refers to accounts receivable that a business determines it will not be able to collect from customers. It arises when a customer, who previously received goods or services on credit, becomes unable or unwilling to pay the amount owed. This can stem from various reasons, such as financial difficulties, bankruptcy, or disputes over the product or service provided.

These uncollectible amounts reduce a company’s assets and profitability. Bad debt expense primarily relates to trade receivables, which are amounts customers owe from the sale of goods or services.

Other types of debt can also become uncollectible, such as a personal loan or an employee advance. Regardless of the type, the core concept remains that the owed amount is deemed irrecoverable. Recognizing this expense accurately ensures financial statements reflect a true picture of a business’s assets and income.

Establishing Uncollectibility

Before a debt can be recognized as bad, certain criteria must be met, and reasonable collection efforts must have been exhausted. A debt is considered uncollectible when there is no reasonable expectation of recovery. This determination requires evidence and sound judgment.

Indicators that a debt may be uncollectible include the debtor’s bankruptcy, death, disappearance, or documented insolvency. If a debtor files for bankruptcy, their ability to repay is severely limited or eliminated. If a debtor cannot be located, collection becomes impossible.

Creditors must demonstrate that they have made genuine attempts to collect the debt. This includes sending demand letters, making phone calls, and engaging collection agencies. Documentation of these efforts, such as records of communication, certified mail receipts, and collection agency reports, is essential to support the claim of uncollectibility.

The expiration of the statute of limitations for debt collection can also render a debt uncollectible from a legal perspective, though the debt itself is not eliminated. Statutes of limitations are state laws that set deadlines, ranging from three to ten years depending on the state and type of debt, within which creditors can file a lawsuit to collect. Even if the legal window for a lawsuit closes, the debt might still appear on credit reports for up to seven years.

Recording Bad Debt Expense

Once a debt is determined to be uncollectible, businesses must record this loss in their financial statements. Two primary accounting methods are used: the direct write-off method and the allowance method. These methods dictate when and how the bad debt expense is recognized.

The direct write-off method recognizes bad debt expense only when a specific account is deemed uncollectible. When this occurs, the bad debt expense account is debited, and the accounts receivable account is credited, directly reducing the outstanding balance. This method is simpler and often used by smaller businesses or for non-material amounts. However, it may not align with generally accepted accounting principles (GAAP) because it records the expense in a period different from when the related revenue was earned, potentially misstating financial performance.

The allowance method estimates uncollectible accounts at the end of each accounting period, aligning with the matching principle of GAAP. This method uses a contra-asset account called “Allowance for Doubtful Accounts” to reduce accounts receivable to their net realizable value. An estimate of future uncollectible amounts is made, debiting Bad Debt Expense and crediting the Allowance for Doubtful Accounts. When a specific account is later determined to be uncollectible, the Allowance for Doubtful Accounts is debited, and Accounts Receivable is credited, without affecting the Bad Debt Expense again. Estimation methods include the percentage of sales method or the aging of receivables method, which categorize receivables by how long they have been outstanding.

Tax Considerations for Bad Debt

The tax treatment of bad debt expense varies depending on whether it is considered a business bad debt or a non-business bad debt. These classifications dictate how the deduction can be claimed on a tax return.

Business bad debts arise from a trade or business. For tax purposes, a business bad debt must be wholly worthless to be deductible, meaning there is no chance of future collection. The Internal Revenue Service (IRS) requires taxpayers to use the direct write-off method for business bad debts, meaning the deduction is taken in the year the debt becomes worthless. Taxpayers using the cash method of accounting cannot claim a bad debt deduction for amounts owed if those amounts were never included in their income. For accrual method taxpayers, if the uncollectible amount was previously included in income, it can be deducted. Detailed guidance for business expenses, including bad debts, can be found in IRS Publication 535.

Non-business bad debts, such as personal loans, are treated differently for tax purposes. These debts must also be wholly worthless to be deductible. Unlike business bad debts, non-business bad debts are treated as short-term capital losses. The deduction is limited; it can first offset short-term capital gains, then long-term capital gains, and finally, up to $3,000 of ordinary income annually. Any remaining loss can be carried over to future years. To claim a non-business bad debt deduction, taxpayers must provide a statement with their tax return, describing the debt, collection efforts, and why it became worthless, confirming it was a bona fide loan and not a gift. This is reported on Form 8949 and Schedule D.