When and How to Write Off Accounts Receivable

Accounts receivable represent money owed to a business for goods or services provided on credit. While these amounts are expected to be collected, some inevitably become uncollectible, leading to bad debt. When a business determines an account receivable will not be paid, it must remove that amount from its financial records through a write-off. This article guides businesses through when an account is uncollectible and the proper accounting and tax procedures for writing off such debts.

Recognizing Uncollectible Accounts Receivable

Determining when an account receivable is uncollectible involves evaluating indicators that suggest payment is unlikely. The age of the receivable is a common factor, as the likelihood of collection decreases significantly the longer an invoice remains unpaid. Businesses often use aging schedules, categorizing receivables by periods such as 30, 60, 90, or more than 120 days past due. Accounts exceeding 90 or 120 days frequently warrant closer scrutiny.

Customer circumstances also indicate uncollectibility. These include the customer filing for bankruptcy, ceasing operations, or experiencing severe financial distress. For instance, if a debtor has entered Chapter 7 bankruptcy, unsecured debts are often discharged, making collection impossible.

Before an account is formally written off, businesses typically exhaust all reasonable collection efforts. This includes sending reminder notices, making phone calls, dispatching formal dunning letters, and potentially engaging third-party collection agencies. Thorough documentation of these failed efforts, including dates of contact and communication logs, provides evidence of a good-faith attempt to collect the debt.

Legal infeasibility can also prompt a write-off when the cost of pursuing legal action outweighs the amount owed. This often occurs with smaller balances where litigation expenses would be economically impractical. Similarly, if a debtor cannot be located despite diligent search efforts, the account may be deemed uncollectible. Detailed documentation of these efforts and the justification for deeming an account uncollectible is necessary for accounting accuracy and potential tax deductions.

Accounting for Bad Debt Write-Offs

Once an account is identified as uncollectible, businesses must formally remove it from their accounting records. The method used depends on the business’s size, accounting basis, and adherence to generally accepted accounting principles (GAAP). Two primary accounting methods for handling bad debts are the direct write-off method and the allowance method.

Direct Write-Off Method

The direct write-off method is simpler and often employed by smaller businesses or those on a cash basis. Under this method, a specific account receivable is directly removed from the books only when deemed uncollectible. For instance, when a $500 invoice is worthless, the business decreases Bad Debt Expense and Accounts Receivable by $500. This method records the expense only at the point of confirmed worthlessness.

Allowance Method

In contrast, the allowance method is GAAP compliant and used by accrual-basis businesses for a more accurate financial picture. This method estimates uncollectible accounts before they are specifically identified, often using historical data or aging analysis. An Allowance for Doubtful Accounts, a contra-asset account, is established to reduce the net realizable value of accounts receivable. For example, if a business estimates $1,000 in uncollectible accounts, it increases Bad Debt Expense and Allowance for Doubtful Accounts by $1,000.

When a specific account is later deemed uncollectible under the allowance method, the actual write-off does not affect the Bad Debt Expense account directly. Instead, the write-off reduces both the Allowance for Doubtful Accounts and the specific Accounts Receivable account. For example, writing off a $200 customer balance involves decreasing the Allowance for Doubtful Accounts by $200 and decreasing Accounts Receivable by $200. This approach ensures expenses are matched with the revenue they helped generate.

Tax Treatment of Written-Off Accounts

The tax treatment of written-off accounts receivable differs from financial accounting methods, governed by IRS regulations. For tax purposes, a debt must be considered “wholly worthless” to be deductible. The IRS generally does not allow deductions for partially worthless debts until the entire debt is deemed uncollectible and collection efforts have ceased.

Businesses must provide documentation to the IRS that the debt is worthless and that bona fide efforts were made to collect it. This supports the claim that the debt has no value. The deduction for a business bad debt is typically taken in the tax year it becomes wholly worthless. This contrasts with financial accounting, where an allowance for estimated uncollectible accounts might be established earlier.

For tax purposes, the distinction between cash and accrual basis accounting is significant. Cash basis businesses generally cannot deduct bad debts from uncollected income, because the income was never recognized for tax purposes. Since the income was never included in taxable revenue, there is no corresponding loss to deduct.

Conversely, accrual basis taxpayers, who recognize income when earned, can deduct business bad debts. This is because the income from the receivable was previously reported and included in their taxable income. The deduction for bad debts is treated as an ordinary business loss, reducing taxable income. Businesses often consult with tax professionals to ensure compliance with IRS requirements.

Handling Recoveries of Previously Written-Off Accounts

Occasionally, a business may receive payment for an account previously written off as uncollectible. This event is known as a recovery, and specific accounting and tax procedures apply to correctly record these funds.

Direct Write-Off Method Recovery

When a previously written-off account is recovered under the direct write-off method, the initial step is to reinstate the account receivable. This involves increasing Accounts Receivable and decreasing Bad Debt Expense for the amount recovered. The cash collection is then recorded by increasing Cash and decreasing the reinstated Accounts Receivable.

Allowance Method Recovery

For businesses using the allowance method, the process also involves two steps. First, the previously written-off account is reinstated by increasing Accounts Receivable and increasing the Allowance for Doubtful Accounts. Second, the receipt of cash is recorded by increasing Cash and decreasing Accounts Receivable.

From a tax perspective, the “tax benefit rule” generally applies to recoveries. If a business deducted a bad debt in a prior tax year and received a tax benefit, any subsequent recovery is considered taxable income in the year collected. However, if the prior deduction did not provide a tax benefit, the recovery is not considered taxable income.