What Does Bad Debt Mean for Accounting and Taxes?
Navigating bad debt involves distinct rules for your financial statements and tax returns. Learn the accounting and tax implications of uncollectible revenue.
Bad debt is an uncollectible receivable that arises when a customer who received goods or services on credit is unable or unwilling to fulfill their payment obligation. For companies that extend credit, the possibility of some accounts becoming uncollectible is an operational reality. The occurrence of bad debt impacts a company’s financial statements by reducing the value of its accounts receivable.
When a Debt Becomes Bad
A debt is not classified as “bad” merely because it is past its due date. A receivable transforms into a bad debt only when there is clear evidence that it has become worthless, meaning there is no reasonable expectation of collection. This determination requires a company to have taken reasonable steps to collect the amount owed.
Definitive proof of worthlessness includes events like a debtor’s bankruptcy, a formal notice of insolvency, or the debtor’s disappearance after abandoning their obligation. For instance, if a customer files for bankruptcy, the portion of their debt that is discharged through the legal process becomes uncollectible. Similarly, if collection agencies report that a debtor cannot be located, or if a sheriff’s writ of execution is returned with a “No Property Found” notation, these serve as objective evidence.
Accounting Methods for Bad Debt
In financial accounting, there are two primary methods for handling bad debts, though only one is widely accepted under Generally Accepted Accounting Principles (GAAP). The simpler approach is the direct write-off method, where a customer’s account is written off to “Bad Debt Expense” when it is deemed uncollectible. This method is not compliant with GAAP for most companies because it fails to match the expense with the revenue in the period the sale was made.
The preferred and GAAP-compliant approach is the allowance method. This method anticipates future bad debts by creating an “Allowance for Doubtful Accounts,” which is a contra-asset account that reduces the total accounts receivable on the balance sheet. At the end of each accounting period, a company estimates the amount of receivables it expects will not be collected and records this as “Bad Debt Expense” and a corresponding credit to the allowance account. This estimation can be based on a percentage of credit sales or an aging of accounts receivable.
When a specific customer’s account is later identified as uncollectible, the write-off is made against the allowance account, not the expense account. The journal entry involves debiting the Allowance for Doubtful Accounts and crediting the specific Accounts Receivable. This action does not impact the income statement at the time of the write-off because the expense was already recognized when the allowance was established.
Tax Treatment of Bad Debts
The Internal Revenue Service (IRS) has specific rules for deducting bad debts, which differ from accounting principles. A distinction is made between business and nonbusiness bad debts, which determines the nature of the tax deduction.
Business bad debts arise from the operation of a trade or business, such as credit sales to customers or loans to suppliers. These are deductible as an ordinary loss against the business’s gross income. This deduction can be taken for both wholly and partially worthless debts in the year they become worthless. For example, a sole proprietor would report this on Schedule C (Form 1040).
Nonbusiness bad debts are all other types of debt, such as a personal loan to a friend that was intended to be repaid. For tax purposes, these must be entirely worthless to be deductible; no deduction is allowed for partially worthless nonbusiness debts. They must be treated as a short-term capital loss, reported on Form 8949. Capital losses are subject to limitations, typically offsetting capital gains plus up to $3,000 of ordinary income per year for individuals.