To calculate bad debt expense, estimate the portion of your accounts receivable that won’t be collected and record it as an expense using one of three methods: the percentage of credit sales method, the accounts receivable aging method, or the direct write-off method. The first two estimate the loss before it happens and are used for financial statements prepared under Generally Accepted Accounting Principles (GAAP). The third records the loss only when a specific account is confirmed uncollectible, and it is what the IRS requires on your tax return. Most businesses run both tracks: an allowance method for the books, direct write-off for taxes.
Which Method Belongs Where
GAAP requires the allowance method for financial reporting, meaning you use either the percentage of credit sales approach or the aging approach to estimate bad debts before they occur. The reasoning is matching: a loss on a credit sale should hit the same period as the sale itself. GAAP permits the direct write-off method only when uncollectible amounts are too small to meaningfully affect the financial statements.
For tax purposes, Congress repealed the reserve method for most taxpayers in the Tax Reform Act of 1986, striking Section 166(c) from the Internal Revenue Code. Nearly every business now uses the specific charge-off method on its return, deducting a bad debt only in the year it actually becomes worthless.
What You Need Before You Calculate
All three methods draw from the same records; each uses a different subset.
- Net credit sales for the period, excluding cash sales and immediate card payments. This drives the percentage of credit sales method.
- Total accounts receivable balance at period end. The aging method and any percentage-of-receivables variation use this.
- Historical loss rates from prior years. Three to five years of data smooths out anomalies and gives a reliable percentage to apply.
- An accounts receivable aging report that sorts every open invoice by how long it has been outstanding, typically in 30-day bands: current, 1–30 days past due, 31–60, 61–90, and 91-plus.
- The existing balance in your allowance for doubtful accounts. The aging method needs this to calculate the adjustment.
Method 1: Percentage of Credit Sales
This is the income statement approach and the simplest to run. Multiply net credit sales for the period by your historical uncollectible rate.
Bad Debt Expense = Net Credit Sales × Estimated Uncollectible Percentage
If your business booked $500,000 in net credit sales this year and roughly 2% of credit sales historically go unpaid, bad debt expense for the period is $10,000. That figure goes straight into your adjusting journal entry.
What sets this method apart is that it ignores the current balance in the allowance for doubtful accounts. You aren’t adjusting the allowance to hit a target; you’re matching a slice of every credit sale to its estimated loss. The focus stays on making the current period’s income statement accurate.
The trade-off is drift. If your percentage is consistently too high or too low, the allowance balance on the balance sheet gradually loses accuracy. Businesses using this method should periodically reconcile the allowance against actual write-offs and recalibrate the percentage. Skipping that reconciliation is a common finding in audits.
Method 2: Accounts Receivable Aging
The aging method is the balance sheet approach. Rather than applying one flat rate to sales, it assigns different loss percentages to different ages of receivables, on the reasoning that older invoices are far less likely to pay.
A typical aging schedule assigns loss rates by bucket:
- Current, not past due: 1%
- 1–30 days past due: 5%
- 31–60 days past due: 10%
- 61–90 days past due: 25%
- Over 90 days past due: 50%
Multiply the dollars in each bucket by its percentage and add the results. That total is the amount the allowance for doubtful accounts should hold at period end. It is a target balance, not the expense itself.
To find the actual expense, compare the target to what’s already sitting in the allowance. If the aging schedule calls for $5,000 in the allowance and the account currently holds a $2,000 credit balance, you record $3,000 in bad debt expense to bring the allowance up to the target. If the allowance instead sits at a $1,000 debit balance (which happens when actual write-offs during the period exceeded the prior estimate), you record $6,000 to reach the $5,000 target.
This method produces a more precise balance sheet because it evaluates the full portfolio against actual payment behavior. Larger companies tend to prefer it: a 90-day-old invoice from a struggling customer carries very different risk than a current invoice from a reliable one, and the aging method captures the difference. Calibrate the bucket percentages to your own customer base and industry. A construction company with long payment cycles will have very different loss rates than a retail distributor.
Method 3: Direct Write-Off
The direct write-off method skips estimation entirely. You record bad debt expense only when a specific account is confirmed uncollectible. No allowance account, no percentages, no aging buckets. The expense hits the books at the moment you give up on collecting.
If three customers owe you $1,200, $800, and $500 and every collection effort has failed, you record $2,500 in bad debt expense when you write those accounts off. The calculation is just the sum of the abandoned invoices.
On the tax side, Section 166 of the Internal Revenue Code governs bad debt deductions. A business bad debt is deductible when it becomes wholly or partially worthless during the tax year. The debt must have arisen in connection with your trade or business, and the amount owed must have been previously included in your gross income. Nonbusiness bad debts follow stricter rules: they must be totally worthless before you can deduct them, partial write-offs aren’t allowed, and the loss is treated as a short-term capital loss subject to capital loss limitations.
GAAP disfavors this method for financial reporting because of timing. A sale made in March that goes bad in November leaves March’s revenue overstated and November’s expenses inflated. Neither period reflects reality. For tax purposes, where the estimation alternative was repealed, this is simply how it works.
Recording the Journal Entries
Allowance Method (Percentage of Sales or Aging)
At period end, record the estimated expense by debiting Bad Debt Expense and crediting Allowance for Doubtful Accounts. Using the percentage-of-sales example, that’s a $10,000 debit to expense and a $10,000 credit to the allowance. Expenses on the income statement rise, and the contra-asset on the balance sheet grows, reducing the net realizable value of accounts receivable.
Later, when a specific customer’s account is determined uncollectible, debit Allowance for Doubtful Accounts and credit Accounts Receivable. This entry doesn’t touch the income statement. The expense was already recorded in the estimation step; the write-off just removes the receivable and draws down the allowance you built.
Direct Write-Off
With the direct write-off method, there is no estimation step. Debit Bad Debt Expense and credit Accounts Receivable directly at the moment you determine the debt is worthless. Expense recognition and removal of the receivable happen in the same entry.
Choosing Between the Two Allowance Methods
For GAAP financial statements, the percentage of credit sales method works well for businesses with consistent sales patterns and relatively uniform customer risk profiles. It’s fast, and it keeps the income statement accurate period to period. The aging method is better when your customer base varies significantly in creditworthiness or when you need a precise balance sheet valuation, which is why auditors tend to prefer it for year-end reporting. Many businesses use the percentage-of-sales method for interim periods and the aging method at year-end to true up the allowance.
For tax purposes, there is no choice. You use the direct write-off approach and deduct bad debts when they become worthless. The only real decision is whether a partially worthless business debt warrants a current-year deduction or whether to wait until the full amount is uncollectible.
One Boundary: CECL Under ASC 326
Entities subject to the Current Expected Credit Losses standard under ASC 326 don’t use the traditional allowance calculations described above in the same way. CECL replaced the older incurred-loss model and requires estimating expected credit losses over the entire remaining life of a receivable, factoring in forecasts of future economic conditions rather than relying solely on historical patterns. CECL took effect for large SEC filers in January 2020 and for all other public business entities and private companies in January 2023. If you fall under ASC 326, the inputs and methodology extend beyond the historical percentages that drive the two allowance methods here.