To calculate bad debt expense, pick one of four methods and apply it to your sales or receivables data: the direct write-off method (record the exact unpaid amount when a specific account is confirmed uncollectible), the percentage of credit sales method (multiply credit sales by a historical loss rate), the accounts receivable aging method (sort unpaid invoices by age and apply a rising loss rate to each bucket), or the percentage of accounts receivable method (apply one loss rate to the full receivable balance). Each produces a different number because each starts from a different data point. The right choice depends on your size, your volume of credit sales, and whether you’re calculating for tax purposes or for GAAP-compliant financial statements.
The Direct Write-Off Method
This is the simplest calculation because there is no estimate. You record bad debt expense only when a specific customer’s account is confirmed uncollectible. Identify the unpaid invoice, debit bad debt expense for that exact amount, and credit accounts receivable to remove it from the books. A customer owes $1,500 and files for bankruptcy? You record $1,500 in bad debt expense at the point you determine recovery is impossible.
The method has a timing problem. The sale often happened months or years before the write-off, so the expense lands in a different period than the revenue it relates to. That violates the matching principle under Generally Accepted Accounting Principles (GAAP), which is why GAAP financial statements use one of the three allowance methods instead.
Where the direct write-off method does matter is taxes. Federal tax law allows a deduction for business debts that become wholly worthless during the tax year, and a partial deduction for the portion of a business debt charged off during the year when only part is recoverable.1Office of the Law Revision Counsel. 26 USC 166 Bad Debts The IRS requires you to demonstrate worthlessness by showing you took reasonable steps to collect; a court judgment isn’t necessary if you can show pursuing one would be futile, but the debt has to actually be worthless before you claim the deduction.2Internal Revenue Service. Topic No. 453, Bad Debt Deduction A statement of facts supporting the deduction must accompany the tax return.3eCFR. 26 CFR 1.166-1 Bad Debts
The Percentage of Credit Sales Method
Sometimes called the income statement approach, this method estimates bad debt expense based on how much credit business you did during the period. Start with total credit sales, not total sales. Cash transactions and credit card payments processed through a bank don’t count because you’ve already received the money or shifted the default risk to the card issuer.
Then apply a historical loss rate. If your records show that roughly 2.5% of credit sales have gone uncollectible over the past several years, that percentage is your multiplier. A quarter with $500,000 in credit sales and a 2.5% loss rate produces a $12,500 bad debt expense. You record this amount immediately, regardless of which specific customers might eventually default.
The strength here is the direct link between current revenue and the expense associated with it, which satisfies the matching principle. The weakness is that the calculation ignores whatever balance already sits in the allowance for doubtful accounts. Over time, if actual write-offs drift away from the estimates, the allowance account can grow too large or too small, so many accountants pair this method with a periodic balance sheet review.
The Accounts Receivable Aging Method
The aging method is the most granular of the four. Instead of applying one percentage to everything, you sort every unpaid invoice into time-based categories and apply a progressively higher estimated loss rate to each one. The logic is intuitive: an invoice 10 days old is far more likely to get paid than one that’s 120 days overdue.
A typical schedule uses buckets like current (not yet due), 1–30 days past due, 31–60 days, 61–90 days, and over 90 days. Assign an estimated uncollectible percentage to each bucket based on your own collection history, then multiply and add:
- Current: $100,000 at 1% = $1,000
- 1–30 days past due: $60,000 at 3% = $1,800
- 31–60 days past due: $30,000 at 8% = $2,400
- 61–90 days past due: $40,000 at 15% = $6,000
- Over 90 days: $20,000 at 35% = $7,000
The total is $18,200. That figure is not the bad debt expense. It’s the target balance for the allowance for doubtful accounts. The expense you actually record is the difference between this target and whatever already sits in the allowance. If the allowance currently holds a $3,200 credit balance, you record $15,000 in bad debt expense to bring it up to $18,200.
The percentages vary widely by industry. Construction companies tend to see a much higher share of receivables in the over-90-day bucket than service industries do, so their loss rates for older invoices are typically steeper. Use your own data first, and supplement with industry benchmarks when internal data is thin.
The Percentage of Accounts Receivable Method
This method works the same way as the aging method but skips the bucket sorting. Apply a single estimated loss percentage to the total outstanding receivable balance. A company with $200,000 in accounts receivable and a 4% historical loss rate calculates an $8,000 target for its allowance account.
As with aging, the expense for the period is the adjustment needed to bring the allowance to the target. If the allowance already holds a $1,000 credit balance from prior periods, only $7,000 goes to bad debt expense. If the allowance has a $500 debit balance, which happens when actual write-offs exceeded prior estimates, you need to record $8,500 to reach the $8,000 credit target.
The approach prioritizes accuracy on the balance sheet because the allowance is recalculated each period against the current receivable balance. The trade-off is less precision than the aging method. Lumping a 10-day invoice and a 150-day invoice into the same pool and applying the same rate smooths over meaningful differences in collectibility. Companies with a fairly uniform customer base and consistent payment patterns can use it comfortably; those with wide variation in customer creditworthiness generally cannot.
Where the Number Lands on Your Financial Statements
All three estimation methods feed into the same account: the allowance for doubtful accounts. On the balance sheet, this account sits directly below gross accounts receivable as a contra-asset, meaning it reduces the receivable balance rather than increasing a liability. Presentation is typically gross accounts receivable minus the allowance, with the result labeled “accounts receivable, net.” A company with $250,000 in gross receivables and a $12,000 allowance shows $238,000 as the net figure.
On the income statement, bad debt expense appears as an operating expense in the period recorded. Under the credit sales method, the amount flows directly from the percentage calculation. Under the aging or percentage of receivables methods, the income statement expense is the plug figure needed to adjust the allowance to its new target. Either way, recording the estimate in the same period as the related revenue keeps financial statements from overstating both assets and income.
Recording the Actual Write-Off and Any Recovery
Calculating bad debt expense and writing off a specific customer’s balance are separate steps. The estimation creates the allowance. The write-off uses it. When a company using one of the three allowance methods determines that a particular customer will never pay, the bookkeeper debits the allowance for doubtful accounts and credits accounts receivable. The income statement isn’t touched because the expense was already recognized during the estimation step. The write-off just removes the specific receivable and draws down the reserve set aside for it.
This is the key difference from the direct write-off method, where the expense hits the income statement at the moment of write-off. Under the allowance approach, that hit happened earlier.
If a customer later pays some or all of a written-off balance, the accounting depends on which method you use. Under the allowance method, reverse the write-off first by debiting accounts receivable and crediting the allowance for doubtful accounts, then record the cash receipt normally. Under the direct write-off method, the reversal credits bad debt expense (or a recovery income account) instead of the allowance.
A Note for Banks and Credit Unions
The four methods above are the standard tools for businesses outside the financial sector. Banks, credit unions, and other financial institutions operate under a different framework. The Financial Accounting Standards Board replaced the older incurred-loss model with the Current Expected Credit Losses (CECL) methodology under ASC Topic 326, which requires institutions to estimate expected credit losses over the entire life of a financial asset at the time it’s originated or acquired.4Board of Governors of the Federal Reserve System. Frequently Asked Questions on the New Accounting Standard on Financial Instruments Credit Losses CECL applies to all banks and credit unions regardless of size.