Bad Debt Expense and Write-Offs

Allowance vs. direct write-off method

The allowance method estimates uncollectible receivables in advance — typically 1-3% of credit sales for service businesses — and sets up an Allowance for Doubtful Accounts on the balance sheet. When a specific invoice goes bad, it's written off against this allowance with no further P&L impact.

The direct write-off method recognizes bad debt only when a specific account is determined uncollectible. It's simpler but violates the matching principle (revenue and the related expense fall in different periods). GAAP requires the allowance method for material amounts; very small businesses sometimes use direct write-off for tax purposes only.

Tax treatment and recovery

For US tax purposes, only the direct write-off method is allowed (IRS Publication 535). You can deduct a business bad debt only when it becomes wholly or partially worthless and you can document collection attempts.

If a written-off customer later pays, you reverse the write-off and recognize the recovery. This is more common than owners expect — especially when the customer's circumstances improve or after a debt-collection agency works the account.

Reserving and writing off

Most businesses use the allowance method: estimate uncollectible amounts each period and book the expense, then write off specific invoices against the allowance when they're identified as uncollectible. The percentage-of-receivables approach (e.g., 1% of all receivables, plus 5% of 31-60, plus 25% of 60+) is simple to implement and adjusts automatically as the aging deteriorates.

The IRS only allows write-offs of specifically identified bad debts, not general allowances, so your tax accounting and book accounting will diverge. Document each write-off with the reason and the collection efforts attempted; in an audit, the IRS wants to see that you genuinely pursued the receivable before giving up.

A bad-debt rate above 1-2% of revenue is a credit-policy problem, not a collections problem. No amount of dunning will fix underwriting that lets the wrong customers through the door in the first place. If write-offs are climbing, look upstream at the credit-approval process and the sales-to-finance handoff.

Build the bad-debt forecast into the cash forecast explicitly. If your historical bad-debt rate is 1.5%, the cash forecast should assume that 1.5% of invoiced revenue never converts to cash and the timing on the rest is the historical collection curve. Forecasts that assume 100% collection of all billed invoices systematically overstate near-term cash and produce false confidence.