To record bad debt expense, you use one of two methods: under the allowance method required by GAAP, you debit Bad Debt Expense and credit Allowance for Doubtful Accounts for an estimated amount, then later debit that allowance and credit Accounts Receivable when a specific invoice goes bad; under the direct write-off method the IRS requires for tax returns, you skip the reserve and debit Bad Debt Expense and credit Accounts Receivable at the moment a specific debt is confirmed uncollectible. Most businesses run both sets of numbers in parallel, because the books and the tax return follow different rules.
Accrual accounting records revenue when it is earned, often before the customer pays. Without an entry for expected losses, receivables on the balance sheet overstate what will actually be collected. The two methods below fix that in different ways and on different timing.
Allowance Method Journal Entries
GAAP requires the allowance method for financial reporting because it matches the estimated loss to the same period the related revenue was earned. You estimate future losses up front and create a contra-asset account, Allowance for Doubtful Accounts, that reduces total receivables on the balance sheet.
The initial entry to build or top up the reserve is:
- Debit: Bad Debt Expense
- Credit: Allowance for Doubtful Accounts
This entry does not touch any specific customer’s balance. It sets aside an estimated amount reflecting the portion of total receivables you do not expect to collect. On the balance sheet, the allowance appears as a subtraction from gross accounts receivable, giving readers the net realizable value.
When a specific invoice is later confirmed uncollectible, you write it off against the existing reserve rather than recording a second expense:
- Debit: Allowance for Doubtful Accounts
- Credit: Accounts Receivable (the individual customer’s balance)
Because the expense was already recognized when you built the reserve, this second entry has no effect on the income statement. It simply reduces both the reserve and the receivable by the same amount.
How to Estimate the Reserve Amount
Two techniques are commonly used to arrive at the number you plug into that first entry. Both should draw on your accounts receivable aging report, which groups outstanding invoices by how long they have been unpaid, typically in buckets of 0–30 days, 31–60 days, 61–90 days, and over 90 days.
Percentage of Sales
Apply a fixed rate, based on your historical loss experience, to total credit sales for the period. If your company generated $500,000 in credit sales and past data shows an average loss rate of 2%, the estimated bad debt expense is $10,000. The rate should reflect your own company’s track record and can be refined as more data accumulates. This method works best when your customer base and credit terms stay relatively stable from period to period.
Accounts Receivable Aging
Assign a different estimated loss percentage to each aging bucket. A receivable 10 days past due might carry a 1% risk of non-payment, while one 100 days overdue might carry 50%. Multiply each bucket’s total by its loss rate, add the results, and the sum becomes the target balance for the allowance account. Because it ties directly to the age and composition of your current receivables, this method tends to produce a more precise estimate.
Under the current GAAP framework, ASC 326 (the Current Expected Credit Losses standard, or CECL), your estimate must also incorporate reasonable and supportable forecasts of future economic conditions, not just historical data.1FASB. Credit Losses Management should consider macroeconomic indicators such as unemployment trends, property values, and industry-specific risk factors when deciding how much to set aside.2Office of the Comptroller of the Currency. Allowances for Credit Losses CECL is now in effect for all entities, including private companies and smaller reporting entities.3Board of Governors of the Federal Reserve System. Frequently Asked Questions on the New Accounting Standard on Financial Instruments – Credit Losses
Direct Write-Off Method Journal Entry
Under the direct write-off method, no reserve exists. You wait until a specific debt is confirmed uncollectible and then record the loss at that point:
- Debit: Bad Debt Expense
- Credit: Accounts Receivable
Straightforward, but it often records the expense in a later period than the one in which the related revenue was earned. That timing mismatch is why GAAP does not permit it for financial reporting. For federal tax purposes, though, 26 U.S.C. § 166 allows a deduction only when a debt becomes wholly or partially worthless during the tax year, and Congress repealed the reserve method for most taxpayers in 1986.4Office of the Law Revision Counsel. 26 USC 166 – Bad Debts So the direct write-off approach is the standard for tax filings.5Internal Revenue Service. Topic No. 453, Bad Debt Deduction Qualifying banks are the notable exception; they can still deduct a reasonable addition to a bad debt reserve under a separate provision.6Office of the Law Revision Counsel. 26 USC 585 – Reserves for Losses on Loans of Banks
The practical consequence: most businesses keep an allowance-based calculation for their financial statements and a specific charge-off record for their tax return.
Supporting Documentation
Whichever method you use, the write-off of a specific account should be supported by records showing you tried to collect and had reason to believe the debt was uncollectible. Useful documentation includes:
- Bankruptcy notices from the debtor
- Customer correspondence, including letters, emails, and call logs of collection efforts
- Legal judgments confirming amounts owed or inability to pay
- Credit bureau reports showing the debtor’s financial condition
Keeping this material organized protects you during financial audits and IRS examinations.5Internal Revenue Service. Topic No. 453, Bad Debt Deduction
Recording a Recovery of a Written-Off Debt
When a customer unexpectedly pays on a debt you already wrote off, use a two-step entry rather than a single one. This preserves the audit trail showing the customer did eventually pay.
Step 1, reinstate the receivable. If you use the allowance method, debit Accounts Receivable and credit Allowance for Doubtful Accounts. If you use the direct write-off method, debit Accounts Receivable and credit Bad Debt Expense. The customer’s balance is now back on the books as an active receivable.
Step 2, record the cash receipt: debit Cash and credit Accounts Receivable.
Doing it in two steps, rather than debiting Cash and crediting Bad Debt Expense in one entry, keeps the customer’s payment history accurate and makes the sequence of events clear to an auditor.
Sales Tax on Uncollectible Accounts
If your business collected and remitted sales tax on a transaction that later became uncollectible, you may be entitled to recover the sales tax portion. Procedures, filing deadlines, and documentation requirements vary by state. Some states allow the credit on a future sales tax return; others require a separate refund application. Deadlines for filing typically range from one to three years after the tax was originally due. Check with your state’s department of revenue for the specific process that applies.
Controls Around Write-Off Approval
Writing off a receivable removes it from the books permanently, which creates a fraud risk worth designing around. An employee with access to both customer accounts and write-off authority could conceal stolen payments by writing off the corresponding receivable. To prevent this, the person who approves write-offs should not be the same person who records payments or maintains the receivable ledger. A formal approval threshold, such as a manager’s sign-off on any write-off above a set dollar amount, adds another layer.
Each write-off should be supported by documentation showing the collection efforts attempted and the reason the account was deemed uncollectible. Periodic reviews of write-off activity by someone outside the accounts receivable function help detect unusual patterns, such as a spike in write-offs tied to a single customer or a single employee’s accounts.