To calculate bad debt expense, pick one of three formulas: write off specific uncollectible invoices as they fail (the direct write-off method), multiply your period’s credit sales by a historical loss percentage (the percentage of credit sales method), or apply graduated loss rates to an aging report of open receivables (the aging method). Which one you use depends on whether the figure is going on a tax return, a GAAP financial statement, or both.
What You Need Before You Run the Numbers
Pull your total credit sales for the period from the general ledger, excluding cash-on-delivery transactions. Pull the ending balance of accounts receivable — what customers owe you at the close of the period. And pull historical data on what share of invoices typically go unpaid after your normal collection efforts are exhausted. That loss rate is the input the two estimation methods are built on.
For the aging method, you also need an aging report that sorts every open invoice by how long it has been outstanding. Most accounting software generates one automatically, with customer name, invoice date, and current balance. For the percentage of credit sales method, the key input is a loss rate derived from several prior years of actual write-offs.
If you intend to deduct any specific account as worthless, keep documentation of your collection efforts: letters, emails, phone logs, and notes on failed payment arrangements. The regulations direct the IRS to weigh all relevant evidence of worthlessness, including the debtor’s financial condition and the value of any collateral, when a deduction is claimed.1eCFR. 26 CFR 1.166-2 – Evidence of Worthlessness
The Direct Write-Off Method
This is the simplest calculation: there isn’t one, really. You identify a specific customer balance that has become uncollectible and remove it. The journal entry debits bad debt expense and credits accounts receivable for the exact dollar amount of that invoice. Nothing is estimated.
The direct write-off method does not comply with generally accepted accounting principles because it violates the matching principle. A credit sale might be recorded in one year and the related loss not booked until the following year or later, when the account is finally declared worthless. GAAP filers use one of the allowance methods below for their financial statements.
For federal taxes, though, the specific charge-off approach is standard. A business may deduct a debt that becomes wholly or partly worthless during the taxable year, provided the amount was previously included in gross income.2Office of the Law Revision Counsel. 26 USC 166 – Bad Debts Most small businesses use the specific charge-off method for tax purposes, identifying and deducting individual debts as they fail.3Internal Revenue Service. Publication 334, Tax Guide for Small Business
The Percentage of Credit Sales Method
This method estimates the period’s loss from the top line. The formula:
Bad Debt Expense = Total Credit Sales × Historical Loss Percentage
Say your business recorded $500,000 in credit sales for the quarter and your records show roughly 2% of credit sales eventually go unpaid. Estimated bad debt expense is $10,000. The adjusting entry debits bad debt expense for $10,000 and credits the allowance for doubtful accounts — a contra-asset account that sits against receivables on the balance sheet — for the same amount.
An important feature: you ignore any existing balance in the allowance account when calculating the entry. The full calculated amount is added to the allowance each period. The focus stays on the income statement, matching estimated losses against the revenue that produced them.
Review the historical loss rate at least once a year. If actual write-offs consistently run above or below the percentage you’ve been using, recalibrate for the next period. The result is a steady, predictable expense that smooths the impact of individual defaults across reporting periods.
The Accounts Receivable Aging Method
The aging method works from the balance sheet. You group outstanding invoices into time buckets reflecting increasing risk, then apply a separate loss percentage to each bucket. Common groupings are 0–30 days, 31–60 days, 61–90 days, and over 90 days past due, with assigned loss rates rising as invoices age — perhaps 1% for the newest invoices and 20% or more for anything over 90 days.
Multiply the dollars in each bucket by its assigned percentage and add the results. A simplified example:
- 0–30 days: $200,000 × 1% = $2,000
- 31–60 days: $50,000 × 5% = $2,500
- 61–90 days: $20,000 × 15% = $3,000
- Over 90 days: $10,000 × 30% = $3,000
Total: $10,500. That is the required ending balance in the allowance for doubtful accounts. The adjusting entry is the difference between that required balance and whatever already sits in the allowance:
Bad Debt Expense Adjustment = Required Allowance Balance − Existing Allowance Balance
If the allowance already carries a $1,500 credit balance from the prior period, you book a $9,000 adjustment: debit bad debt expense, credit the allowance. If the allowance sits in a debit position (which happens when actual write-offs exceeded the earlier estimate), add that debit balance to the required amount rather than subtracting it.
Because every open dollar is evaluated by age, the aging method produces a more precise valuation of receivables at a given date. It fits companies with large, varied customer bases where payment patterns differ sharply by account.
Which Method Fits Your Situation
For federal income tax, the IRS generally requires the specific charge-off method, where individual debts are deducted only when they are identifiably worthless. A narrow exception exists for certain accrual-basis service businesses — health care, law, engineering, and accounting firms with average annual gross receipts within the threshold set by IRC § 448 — which may use the nonaccrual-experience method instead.3Internal Revenue Service. Publication 334, Tax Guide for Small Business
For financial reporting under GAAP, an allowance method (percentage of credit sales or aging) is required so that the estimated loss falls in the same period as the revenue that created the receivable. Companies reporting under current GAAP must also apply the current expected credit losses framework under ASC 326, which calls for estimating losses over the full expected life of a receivable rather than waiting for a loss event.4Financial Accounting Standards Board. FASB Staff Q&A Topic 326, No. 2 – Developing an Estimate of Expected Credit Losses on Financial Assets CECL has applied to all entity types — SEC filers, other public companies, and private companies — for fiscal years beginning after December 15, 2021.5Board of Governors of the Federal Reserve System. Frequently Asked Questions on the New Accounting Standard on Financial Instruments – Credit Losses
In practice, a sole proprietor filing Schedule C often uses direct write-off for both books and taxes. A mid-size company usually keeps an aging schedule for monthly financial statements and converts to the specific charge-off method at year-end for the tax return.
Recording a Recovery When a Written-Off Account Pays
Sometimes a customer pays after the balance has been written off. The entries depend on which method recorded the original loss.
Under an allowance method, reverse the write-off first: debit accounts receivable and credit the allowance for doubtful accounts to reinstate the customer’s balance. Then record the payment: debit cash, credit accounts receivable. The allowance absorbs the reversal, so bad debt expense is not touched.
Under the direct write-off method, the reinstatement entry debits accounts receivable and credits bad debt expense, reversing the original charge. Record the payment the same way: debit cash, credit accounts receivable. Because the original loss ran through bad debt expense, the recovery reduces current-period bad debt expense.