How to Write Off Uncollectible Accounts Receivable

Businesses routinely extend credit, generating accounts receivable for goods or services provided. While most amounts are collected, some inevitably become uncollectible. Writing off these uncollectible accounts, or bad debts, is a standard accounting practice. This process ensures accurate financial reporting by removing assets that no longer have value and has important tax implications.

Determining Uncollectible Accounts

Before an account can be written off, a business must determine it is genuinely uncollectible. This requires assessing specific criteria and due diligence. Common indicators include customer bankruptcy, disappearance, or unsuccessful, documented collection efforts.

Businesses should exhaust reasonable collection attempts before deeming an account uncollectible. This includes sending invoices, making follow-up calls, issuing demand letters, and potentially engaging third-party collection agencies. The duration of delinquency, often tracked through an aging report, also plays a significant role, as collection likelihood decreases the older an account becomes.

Comprehensive documentation is essential to support the determination of an uncollectible account. This evidence includes copies of invoices, communication records (emails, call logs), legal notices like bankruptcy filings, and internal memos detailing collection efforts and the write-off decision. An aging report, categorizing outstanding balances by age, further supports this.

Internal policies and procedures guide the identification and approval of bad debt write-offs. These policies define the conditions under which an account is uncollectible, outline required collection steps, and designate authorized individuals or departments. Clear guidelines ensure consistency and proper governance in managing accounts receivable.

Recording Write-Offs in Accounting

Once an account is determined uncollectible, it must be formally removed from financial records through a write-off. Businesses use one of two accounting methods for bad debts: the Direct Write-Off Method or the Allowance Method. The choice impacts when bad debt expense is recognized on financial statements.

The Direct Write-Off Method recognizes bad debt expense only when a specific account is identified as uncollectible. This method is simpler and typically used by smaller businesses or when uncollectibility is infrequent. For example, if a business determines a $1,000 account receivable is uncollectible, the journal entry involves debiting Bad Debt Expense for $1,000 and crediting Accounts Receivable for $1,000.

The Allowance Method estimates uncollectible accounts at the end of each accounting period to align expenses with the revenue they helped generate, adhering to the matching principle. This method establishes an “Allowance for Doubtful Accounts,” a contra-asset account that reduces the total accounts receivable balance to reflect the amount expected to be collectible. Estimation techniques include the percentage of sales method, which applies a percentage to total credit sales, or the aging of receivables method, which categorizes receivables by age and applies increasing uncollectibility percentages to older accounts.

Under the Allowance Method, two journal entries are involved. First, establishing the allowance involves debiting Bad Debt Expense and crediting Allowance for Doubtful Accounts for the estimated uncollectible amount. Second, when a specific account is later deemed uncollectible, it is written off against the allowance by debiting Allowance for Doubtful Accounts and crediting Accounts Receivable. This write-off does not affect Bad Debt Expense at the time, as the expense was already recognized when the allowance was established.

The impact on financial statements differs between the methods. The Direct Write-Off Method records the expense when the specific debt is identified, potentially leading to a mismatch between revenues and expenses if the sale occurred in a prior period. The Allowance Method, by estimating and recognizing bad debt expense in the same period as related revenues, provides a more accurate measure of receivables’ expected realizable value on the balance sheet and aligns with Generally Accepted Accounting Principles (GAAP).

Tax Treatment of Bad Debts

The tax treatment of bad debts has specific rules that often differ from financial accounting practices. For tax purposes, generally only the Direct Write-Off Method is permitted for deducting specific business bad debts when a debt becomes wholly or partially worthless. Taxpayers using the cash method of accounting cannot claim a bad debt deduction for unpaid income items, such as wages or rent, because these amounts were never included in their taxable income.

To deduct a bad debt for tax purposes, the Internal Revenue Service (IRS) requires that the debt be “worthless.” A debt becomes worthless when facts and circumstances indicate no reasonable expectation of repayment. This determination requires showing reasonable collection steps were taken and that a court judgment would likely be uncollectible. Documentation, including evidence of collection attempts, is crucial.

The IRS distinguishes between business and non-business bad debts. A business bad debt is a loss from a debt created or acquired in a trade or business, or one that became worthless in connection with the trade or business. Business bad debts are deductible as ordinary business expenses. Non-business bad debts must be completely worthless to be deductible and are treated as short-term capital losses, subject to capital loss limitations.

The reserve method, akin to the allowance method in financial accounting, is generally not permitted for tax purposes, except for certain financial institutions. Instead, businesses use the specific charge-off method for tax deductions, where each specific worthless debt is identified and deducted. If a previously written-off bad debt is recovered, the amount recovered must generally be included in taxable income under the tax benefit rule, but only to the extent the prior deduction reduced the taxpayer’s tax liability.