When to Write-off Bad Debt

Gartner research indicates that bad debt saw a notable increase of 26% in 2020. This surge is not unexpected, considering the economic uncertainty triggered by the global pandemic, which contributed to a significant rise in corporate bad debt. Additionally, many businesses experienced revenue losses due to the drastic shift in consumer behavior and spending habits.

As the economy continues to change, businesses must refine their strategies to better manage bad debt. But how can you determine when it's the right time to write off bad debt, and how can you reduce its impact moving forward?

Understanding the proper timing and method for writing off bad debt is critical to maintaining financial health. Businesses should regularly review outstanding receivables, monitor customer creditworthiness, and set clear collections processes to avoid unnecessary write-offs. Furthermore, implementing proactive credit risk management tactics and offering diverse payment options can help reduce the future risk of bad debt.

What is bad debt?

Bad debt describes an unpaid debt that is unlikely to be recovered from. It can have a negative impact on a company's balance sheet, cash flow, and profitability.

In accounting terms, bad debt becomes a "bad debt expense" that must be charged against your company's accounts receivable. When a customer purchases goods or services on credit and then fails to pay the invoice—whether because they've gone out of business, filed for bankruptcy, or simply refuse to pay—the amount they owe transitions from being an asset (accounts receivable) to an expense on your income statement.

Bad debt is sometimes also referred to as a "doubtful debt" or "uncollectible account." The distinction matters: a doubtful debt is one you suspect may not be paid but haven't confirmed yet, while a bad debt is one you've determined is truly unrecoverable. This difference is important because it affects how and when you record the expense in your books. If your business extends net terms to customers, understanding this distinction is essential for keeping your cash flow healthy and your financial statements accurate.

When should a business write off a bad debt?

Any business that has accounts receivable will, at some point, face the risk of an uncollectible debt (also known as a bad debt or a doubtful debt). It's the same for businesses that offer net terms. They'll have to face the question: at what point should this AR be written off the bad debt?

There isn't a simple answer to this question. Businesses vary in their operations and have different criteria for when they should write off bad debt.

Keeping bad debt in AR will increase AR and days sales outstanding (DSO). This increase can skew balance sheet and working capital reports, but it isn't necessarily a bad thing. Knowing bad debt is there can be motivation enough to continue trying to collect on it. But at some point, the collection period becomes too long.

On the other hand, bad debt can trigger policy changes that improve a company's credit policy and B2B credit management. If you're able to transfer a customer to a payment plan, it makes sense to keep bad debt on the books as AR until it's paid in full.

The general rule is to write off a bad debt when you're unable to connect with your client. You should also write it off if they haven't shown any willingness to set up a payment plan, or the debt has been unpaid for more than 90 days.

Signs it's time to write off a bad debt

Deciding the right moment to write off a bad debt can be difficult, but there are clear warning signs that a debt has become uncollectible. Use the following checklist to evaluate whether it's time to move forward with a write-off:

1. The customer is unresponsive. You've sent multiple invoices, reminders, emails, and made phone calls—but the customer hasn't responded in 60 to 90 days or more. A consistent lack of communication is one of the strongest indicators that payment isn't coming.

2. The customer has filed for bankruptcy. If your customer has filed for Chapter 7 or Chapter 11 bankruptcy, the full amount of the debt may be unrecoverable. In Chapter 7 cases especially, unsecured creditors like trade suppliers are often last in line for any distribution of assets.

3. The customer's business has closed. When a customer shuts down operations, closes their physical premises, or dissolves their business entity, the chances of recovering the debt drop significantly. Verify this by checking state business registrations or using a credit check tool.

4. The debt has exceeded your internal aging threshold. Most companies set an internal policy—often 90, 120, or 180 days past due—after which a debt is escalated to collections or written off. If the invoice has exceeded this threshold and all collection attempts have failed, it's time to write it off.

5. The customer disputes the debt and refuses to negotiate. If there's an unresolvable dispute about the goods or services delivered and the customer refuses to negotiate or compromise, you may not have a viable path to collection without legal action—which may cost more than the debt itself.

6. The cost to collect exceeds the debt amount. Collection agencies typically charge 25% to 50% of the recovered amount. If the outstanding balance is small relative to collection costs, the effort isn't worth the return. Legal fees for civil suits can also quickly outpace the value of smaller debts.

7. Your collection agency has returned the account. When a professional collection agency returns the account as uncollectible after their efforts, this is a strong signal that all reasonable avenues have been exhausted.

Writing off bad debt: allowance method or direct write-off method

There are a number of ways to write off bad debt. Regardless of the method chosen, you'll need a journal entry that balances a bad debt entry. Here are the two key methods for writing off bad debt.

1. The allowance method

The allowance method is a proactive approach where businesses estimate their future bad debts at the end of each accounting period and set aside a reserve before any specific debt actually goes bad. The bad debt amount is recorded in a specific "allowance for doubtful accounts" (also known as a bad debt reserve), which is a contra-asset account. This means it offsets your accounts receivable on the balance sheet, reducing the total AR to a more realistic figure.

Here's how it works in practice. At the end of each period, you estimate the dollar amount of receivables you don't expect to collect—based on historical data, aging reports, and current economic conditions. You then record a journal entry:

Step 1: Estimate and record the allowance

• Debit: Bad Debt Expense (income statement)
• Credit: Allowance for Doubtful Accounts (balance sheet, contra-asset)

Step 2: When a specific debt is confirmed uncollectible

• Debit: Allowance for Doubtful Accounts
• Credit: Accounts Receivable

For example, suppose your company has $500,000 in total accounts receivable at year-end. Based on your history and AR management data, you estimate that 3% (or $15,000) will be uncollectible. You'd debit Bad Debt Expense for $15,000 and credit Allowance for Doubtful Accounts for $15,000. Later, when Customer X's $2,000 invoice is confirmed uncollectible, you'd debit the Allowance for $2,000 and credit Accounts Receivable for $2,000—without any additional impact on your income statement.

The allowance method is the preferred approach under Generally Accepted Accounting Principles (GAAP) because it follows the matching principle—expenses are recorded in the same period as the revenue they relate to. This gives a more accurate picture of profitability in any given period.

2. The direct write-off method

The direct write-off method is simpler and more reactive. Instead of estimating future bad debts, you wait until a specific invoice is confirmed uncollectible and then record the expense at that point. You make a debit journal entry under bad debt expense and a corresponding credit entry under accounts receivable. (If your company has a full-time accountant, they'll likely already have their own way of highlighting doubtful accounts and handling bad debts.)

The journal entry is straightforward:

• Debit: Bad Debt Expense
• Credit: Accounts Receivable

For example, if Customer Y owes $5,000 and you've determined after months of collection efforts that they will never pay, you'd debit Bad Debt Expense for $5,000 and credit Accounts Receivable for $5,000. There's no intermediate account—the debt goes directly from AR to an expense.

While the direct write-off method is easy to implement, it has a significant drawback: it doesn't comply with GAAP's matching principle. Revenue from the sale might have been recorded in Q1, but the bad debt expense might not be recognized until Q3 or Q4—making your financial statements less accurate in both periods. The IRS, however, does require businesses to use the direct write-off method (also known as the specific charge-off method) for calculating tax deductions on bad debts.

Allowance method vs. direct write-off: side-by-side comparison

Many businesses use both methods: the allowance method for their financial reporting (to stay GAAP-compliant) and the direct write-off method for their tax returns (as required by the IRS). If you're unsure which method is right for your business, consult with your accountant or credit management team.

Publicly traded companies that follow the Generally Accepted Accounting Principles (GAAP) and are regulated by the SEC use the allowance method for financial reporting. However, for tax purposes, they still use the direct write-off method. Once the debt has been determined uncollectible, it goes directly from AR to an expense. There is no intermediate account reflected in the financial statements.

If you don't want the debt in AR but still need a way to track it, so it isn't totally written off, you may want to create a separate AR account for each collection. This way, the primary AR balance can run reports without bad debts affecting it, but you can still track each collection account. Basically, this is using a sub-ledger for tracking.

When to decide that a bad debt is uncollectible

No matter how bad debt is tracked, there must come a point when it is decided the debt is ultimately uncollectible and must be written off—no matter the amount of bad debt. We'll look at a specific solution to avoid this problem further down.

Before you write off the debt, you'll need to be able to prove to the IRS that you've taken sufficient steps to collect the debt, because bad debts lower your business' taxable income.

Note: Recording a bad debt expense is only needed if you work with accrual accounting. If you use cash accounting, you won't have an entry for the collectible amount because you never received payment. Unfortunately, it still creates a problem for cash flow.

Once a company's internal credit collection policy has run its course, the next step is usually hiring a collection agency or looking into debt collection software.

Understanding AR aging and bad debt decisions

An accounts receivable aging schedule (also called an aging report) is one of the most important tools for deciding when to write off bad debt. It categorizes your outstanding invoices into time-based "buckets" showing how long each invoice has been unpaid. A typical aging schedule breaks receivables into the following categories: current (0–30 days), 31–60 days, 61–90 days, and 90+ days past due.

The older a receivable is, the less likely it is to be collected. Industry data generally shows that invoices past 90 days have a significantly lower probability of recovery compared to those in the 0–30 day range. This is why many companies use their aging report to trigger specific actions at each stage—sending reminders at 30 days, escalating to a collections team at 60 days, and evaluating for write-off at 90 or 120 days.

If you're using the allowance method, your aging report is also how you estimate your bad debt reserve. For example, you might assume that 1% of current receivables will go unpaid, 5% of receivables in the 31–60 day bucket, 15% of receivables in the 61–90 day bucket, and 30% or more of receivables over 90 days. These percentages should be calibrated to your own historical collection data and adjusted as economic conditions change. For better visibility into your aging trends, consider using AR automation software that generates aging reports automatically.

Using daily sales outstanding averages as an accounting period

To keep daily sales outstanding (DSO) from being skewed, bad debt might be written off after a certain number of days. For example, if your company's average DSO is 75 days, you might decide that after an additional 90 or 120 days, the debt should be sent to collections and written off.

DSO is only one example. Some companies pay corporate fees for carrying bad debt. Rather than 165 or 195 days, as in the above example, the company may settle on 150 days in order to limit the carrying expense.

You should always be able to see your bad debts on your general ledger. They get listed on your income statement under 'selling, general, and administrative costs' (SG&A). Remember that your bad debts will influence your net income and you may need to look at how you handle your financial obligations if you have too many outstanding accounts in your books.

How to calculate the bad debt expense formula

There are two main methods for estimating bad debt expense: the percentage of sales method and the percentage of receivables method. Both are used with the allowance method to determine how much to set aside in your bad debt reserve.

Method 1: Percentage of sales

The percentage of sales method estimates bad debt as a percentage of total credit sales for the period. The formula is:

Bad Debt Expense = Total Credit Sales × Estimated Bad Debt Percentage

Example: Your company made $800,000 in credit sales this quarter. Based on the last three years of data, an average of 2% of credit sales have gone uncollected. Your estimated bad debt expense for the quarter would be:

$800,000 × 0.02 = $16,000

You would record a journal entry debiting Bad Debt Expense for $16,000 and crediting Allowance for Doubtful Accounts for $16,000.

To calculate your company's historical bad debt percentage, use this formula:

Percentage of Bad Debt = Total Bad Debts ÷ Total Credit Sales

For instance, if your company had $30,000 in confirmed bad debts last year on $1,500,000 in credit sales, your bad debt percentage would be $30,000 ÷ $1,500,000 = 2%.

Method 2: Percentage of receivables (aging method)

The percentage of receivables method focuses on the balance sheet rather than the income statement. You look at your total outstanding accounts receivable and use your aging schedule to estimate how much won't be collected. The formula is:

Required Allowance Balance = Total Accounts Receivable × Estimated Uncollectible Percentage

Example: Your company has $400,000 in outstanding receivables. Using your aging report, you apply different estimated default rates to each bucket:

In this example, you'd need $20,750 in your Allowance for Doubtful Accounts. If the allowance already has a $5,000 balance from the prior period, you'd record a Bad Debt Expense of $15,750 ($20,750 – $5,000) to bring the allowance up to the required amount.

Startups and small businesses are advised to set up a bad debt allowance account (also known as a bad debt expense account or bad debt reserve) in advance of issuing credit. If you're reading this, you may already have bad debts. The good news is that you can calculate your current percentage of bad debt and set up an allowance for bad debts that you can draw from to cover the amount of your bad debts.

You'll also set up a receivable aging schedule to estimate the bad debts. Using invoice automation can make this process more efficient and accurate by generating aging reports in real time.

A sales method and solution to bad debts

In a perfect world, you'd never do business with a client who couldn't pay their invoices in a timely manner, and you'd never have to record bad debt! We can't offer that (yet), but with online net terms, we're getting much closer.

Resolve Pay is a popular digital net terms partner that can help you reduce bad debts down to 0%. Resolve's proprietary credit assessment uses proprietary financial databases and algorithms to assess your customers without needing a single data point from them. All they need is the company name, email, and address. When a customer is approved for credit, Resolve provides an advance of up to 90% of each invoice, paid into your account within 1 day.

This means you can check the creditworthiness of any potential client before extending net terms to them, and you'll be confident that the payment terms and credit limit you're offering is appropriate for their payment abilities. Your accounts receivable balance will always be manageable and healthy.

Too often, sales professionals rely on intuition and past experience to recommend net terms when they don't even know how to read an Experian Credit report! Now, you can use Resolve and eliminate all uncollectible accounts.

When the cost to collect outweighs bad debt

If a client has closed down their physical premises or becomes unresponsive, collecting debt becomes more time-consuming and expensive. When this is the case, the cost — both in money and time — of collecting a debt has to be weighed against the amount of debt being collected.

If you win a civil case against a client and are awarded a judgment, you then have to take action to collect payment. This often comes in the form of garnishment.

Even if you have a judgment against a client, it doesn't mean you'll be able to collect payment. If the client files for bankruptcy, the full amount of the debt may be unrecoverable. If the client has no money, the debt is unrecoverable.

How to handle unexpected payments

Sometimes you get a surprise payment of a bad debt that you've already written off. The money you just collected is certainly real and must be accounted for.

As we've mentioned, once a debt is determined uncollectible, it's moved from AR to a bad debts account and it becomes an expense. You may create an adjusting entry so the funds can go into a bad debt recovery account. The accounting methods we mentioned earlier have different ways of dealing with recovered funds.

If you used the direct write-off method, recovering a previously written-off debt requires two journal entries. First, you reverse the original write-off by debiting Accounts Receivable and crediting Bad Debt Expense (or a Bad Debt Recovery account). Then, you record the cash receipt by debiting Cash and crediting Accounts Receivable. This two-step process reinstates the receivable and then clears it with the payment.

If you used the allowance method, the recovery is similar but the credit in the first entry goes to the Allowance for Doubtful Accounts instead of Bad Debt Expense. You debit Accounts Receivable and credit the Allowance, then debit Cash and credit Accounts Receivable. This restores the allowance balance and properly tracks the recovered amount.

Virtually all companies have one thing in common when it comes to bad debt: it should eventually be written off. Discussing with your team what makes the most sense will help in determining the right time to write off bad debts.

Bad debt tax deductions: what the IRS requires

One of the benefits of writing off bad debt is the potential tax deduction. However, the IRS has specific requirements you need to meet before you can claim the deduction. Understanding these rules can help your business recover some value from an otherwise total loss.

For business bad debts, the IRS allows you to deduct the debt in full or in part—but only if the amount owed was previously included in your gross income. For businesses using accrual accounting, this typically means the revenue from the sale was already reported on a prior tax return. Cash-basis taxpayers can only claim a deduction if the income was previously included in gross income; if payment was never reported as income, you cannot deduct it as bad debt.

To claim the deduction, the IRS requires that you demonstrate the debt is legitimately worthless. You'll need to show that you made reasonable collection efforts—documented phone calls, emails, letters, and any correspondence with collection agencies. You don't necessarily need to file a lawsuit, but you should be able to demonstrate that a court judgment would be uncollectible.

Business bad debts can be deducted on Schedule C (Form 1040) for sole proprietors or on the applicable business tax return for other entity types. The deduction must be taken in the year the debt becomes worthless—or partially worthless, in which case you can deduct only the portion you've charged off on your books.

For detailed guidance on bad debt deductions, consult the IRS Topic No. 453 or speak with your tax advisor. Good documentation is key: maintain records of the original sale, all invoices, payment history, and every collection attempt you made. This paper trail protects your deduction in the event of an audit.

How to avoid bad debts

There is an actual solution to avoiding bad debts. And it's not accounts receivables insurance or accounts receivables collections software.

It's Resolve Pay. We help B2B companies scale their accounts receivables operations - including collections. Learn how you can reduce your bad debts by 100% with Resolve's accounts receivables solution.

Frequently asked questions about bad debt write-offs

What is the journal entry for writing off bad debt?

The journal entry depends on which method you use. Under the direct write-off method, you debit Bad Debt Expense and credit Accounts Receivable for the full amount of the uncollectible invoice. Under the allowance method, you first estimate future bad debts by debiting Bad Debt Expense and crediting Allowance for Doubtful Accounts. When a specific debt is confirmed uncollectible, you then debit the Allowance and credit Accounts Receivable. The allowance method is required under GAAP, while the direct write-off method is used for tax purposes.

Can you write off bad debt on your taxes?

Yes. If your business uses accrual accounting and you previously reported the revenue from the sale as income, you can deduct the bad debt on your tax return. The IRS requires you to use the specific charge-off (direct write-off) method for tax deductions. Business bad debts are deducted as an ordinary loss on your business tax return. You must take the deduction in the year the debt becomes wholly or partially worthless, and you need documentation showing you made reasonable collection efforts.

How long should I wait before writing off a bad debt?

There's no single rule, but most businesses set an internal threshold between 90 and 180 days past due. The key factors include your company's average DSO, the cost of carrying the debt, and whether any collection efforts are still active. Some businesses wait until a collection agency has returned the account as uncollectible. The important thing is to have a consistent policy documented in your credit management guidelines.

What is the difference between bad debt and doubtful debt?

A doubtful debt is a receivable that you suspect may not be collected—it's still uncertain. A bad debt is a receivable that has been confirmed as uncollectible and is ready to be written off. In the allowance method, you estimate doubtful debts as a reserve. Once a specific debt is determined to be uncollectible, it transitions from doubtful to bad and is written off against that reserve.

What happens when you collect on a debt that was already written off?

This is called a bad debt recovery. You'll need to reverse the original write-off entry and then record the cash received. Under the direct write-off method, you reinstate the receivable by crediting Bad Debt Recovery (or reversing the Bad Debt Expense) and then record the payment as normal. Under the allowance method, you credit the Allowance for Doubtful Accounts to reinstate the receivable, then record the cash. Either way, the recovered funds must be properly documented in your books.

Does writing off bad debt affect my credit score?

Writing off bad debt in your accounting books does not directly affect your business credit score—it's an internal accounting action. However, if the customer who owes you the debt is reported to a business credit bureau as delinquent, it can affect their credit score. On the flip side, if your business has significant bad debt write-offs that impact your financial ratios (like your working capital ratio), lenders may view your creditworthiness differently when you apply for financing.

What is a bad debt ratio, and what is considered normal?

The bad debt ratio measures the percentage of your accounts receivable or credit sales that end up as uncollectible. You can calculate it as Total Bad Debts ÷ Total Credit Sales. Industry benchmarks vary, but many B2B companies aim for a bad debt ratio below 1–2%. If your ratio is consistently above this range, it may be a sign that your credit risk assessment process needs to be strengthened—or that you should consider a net terms partner like Resolve Pay to shift credit risk off your balance sheet.

How can B2B businesses prevent bad debt in the first place?

Prevention starts with strong credit policies. Run automated credit checks on every new customer before extending net terms. Set appropriate credit limits based on the customer's financial health, not just the size of the order. Monitor your AR process closely and follow up on overdue invoices quickly—the sooner you act, the more likely you are to collect. Consider offering early payment discounts to incentivize faster payment. And for the most robust protection, work with a net terms financing partner like Resolve Pay that conducts credit assessments and advances you cash on approved invoices, so you never have to worry about uncollectible accounts again.