How to Write Off Accounts Receivable for a Business

Accounts receivable (AR) represents the money a business is owed by its customers for goods or services delivered but not yet paid for. These amounts are recorded as current assets on a company’s balance sheet, reflecting expected future cash inflow. Not all accounts receivable are ultimately collected; a customer may be unable or unwilling to pay, making the receivable “uncollectible.” When this occurs, businesses must “write off” the uncollectible amount, an important accounting and tax process to accurately reflect their financial position.

Identifying Uncollectible Accounts

Determining when an account receivable becomes uncollectible involves assessing specific criteria and following an internal process. An account is considered uncollectible when there is virtually no chance of receiving payment. This can happen for various reasons, such as a customer filing for bankruptcy, disappearing, or refusing to pay after repeated attempts.

Businesses use internal processes to evaluate collectibility. These include reviewing aging reports, which categorize receivables by age. Collection efforts, such as sending reminder notices, making phone calls, and direct communication with the customer, are also part of this assessment. If these efforts prove futile, or if a customer’s financial viability deteriorates, the debt becomes probable to be uncollectible. Establishing a clear internal policy for identifying these accounts ensures consistency and guides judgment based on evidence that collection is improbable.

Accounting Methods for Writing Off Accounts Receivable

Once an account is identified as uncollectible, businesses use specific accounting methods to record the write-off in their financial records. The two primary methods are the direct write-off method and the allowance method. The choice often depends on the business’s size and the materiality of the uncollectible amounts.

The direct write-off method is simpler and used by smaller businesses or for immaterial amounts. Under this method, the business waits until a specific account is deemed uncollectible before recording the expense. The journal entry involves debiting “Bad Debt Expense” and crediting “Accounts Receivable” for the amount being written off. This method directly impacts the income statement when the uncollectible is confirmed, but it may not align the expense with the revenue earned in the same accounting period.

The allowance method is more accurate for financial reporting as it adheres to the matching principle, which matches expenses with related revenues. This method involves estimating uncollectible accounts at the end of an accounting period. Common estimation techniques include the percentage of sales method or the aging of receivables method. The initial journal entry debits “Bad Debt Expense” and credits “Allowance for Doubtful Accounts,” a contra-asset account that reduces the value of accounts receivable on the balance sheet. When a specific account is later determined to be uncollectible, a separate entry is made: debiting “Allowance for Doubtful Accounts” and crediting “Accounts Receivable.”

Tax Implications of Bad Debt Write-Offs

Writing off bad debts can have tax implications, as these amounts may be deductible expenses for businesses, reducing their taxable income. The Internal Revenue Service (IRS) distinguishes between business bad debts and nonbusiness bad debts; for accounts receivable write-offs, the focus is on business bad debts. To be deductible, a debt must be considered truly worthless, represent a bona fide debt, and have been previously included in the business’s income.

For tax purposes, most businesses use the specific charge-off method for deducting bad debts, even if they use the allowance method for financial reporting. This method allows a deduction in the tax year the debt becomes wholly or partially worthless and is charged off on the business’s books. The IRS requires evidence that reasonable efforts were made to collect the debt and that there was an identifiable event establishing its worthlessness. An “Allowance for Doubtful Accounts” is not deductible for tax purposes until the specific debt is deemed worthless.

If a debt previously written off and deducted is later collected, it is considered a “bad debt recovery.” Under the tax benefit rule, the recovered amount must be included in the business’s gross income in the year of recovery, but only up to the amount that provided a tax benefit in the prior deduction. This ensures businesses do not receive a double benefit from both the deduction and subsequent collection.

Documenting Bad Debt Write-Offs

Maintaining documentation for bad debt write-offs is important for accurate accounting and compliance with tax regulations. These records serve as evidence that a debt was uncollectible. Proper documentation helps a business withstand audits and prove worthlessness to the IRS.

Key Records for Bad Debt Write-Offs

Key records include:
Customer correspondence (emails, letters, collection notices) demonstrating collection efforts.
Evidence of these efforts, such as call logs or reports from collection agencies.
Customer financial information (bankruptcy filings, credit reports) providing proof of the debtor’s inability to pay.
Internal documents like write-off authorization forms or memos, aging reports, and journal entries confirming the write-off.
Legal documentation related to the debt.

Businesses should keep records supporting bad debt deductions for at least seven years.