Bad Debt: Definition, Recording, and Estimation

Key takeaways

• Bad debt is receivable (or loan) value that a creditor expects will not be collected and must be written off.
• Under accrual accounting and GAAP, companies generally use the allowance method to estimate bad debt so expenses match the period of the related sales. The direct write-off method is commonly used for tax purposes.
• Two common estimation methods are the accounts receivable (AR) aging method and the percentage-of-sales method.
• Businesses and individuals may be able to deduct bona fide bad debts on tax returns; nonbusiness bad debt is typically treated as a short‑term capital loss.

What is bad debt?

Bad debt is an amount owed to a lender, supplier, or seller that is unlikely to be collected because the debtor cannot or will not pay (for example, due to bankruptcy, insolvency, or refusal). It represents a loss to the creditor and reduces the net realizable value of accounts receivable.

Why it matters

Extending credit is part of doing business, and some defaults are inevitable. Properly estimating and recording bad debt:
* Provides a more accurate balance sheet by reducing accounts receivable to the amount expected to be collected.
* Matches bad debt expense to the same period as the revenue that gave rise to the receivable (matching principle).
* Helps management budget and assess credit risk.

Recording bad debt (journal entries)

Allowance method (GAAP-preferred):
1. Estimate uncollectible receivables and record:
* Debit Bad Debt Expense
* Credit Allowance for Doubtful Accounts (contra‑asset to AR)
2. When a specific receivable is written off:
* Debit Allowance for Doubtful Accounts
* Credit Accounts Receivable
3. If a written-off account is later recovered, typical steps are:
* Reinstate the receivable: Debit Accounts Receivable, Credit Allowance for Doubtful Accounts
* Record cash collection: Debit Cash, Credit Accounts Receivable
* Alternatively, record a bad debt recovery item if recovery is small.

Direct write-off method (tax practice):
* When an account is deemed uncollectible:
* Debit Bad Debt Expense
* Credit Accounts Receivable
* This records the precise write-off but may violate the matching principle and is generally not accepted under GAAP for financial reporting.

Methods for estimating bad debt

Accounts receivable (AR) aging method

Group outstanding receivables by age and apply different uncollectible percentages to each age bucket. Older receivables usually have higher percentages.

Example:
* $70,000 AR < 30 days × 1% = $700
* $30,000 AR ≥ 30 days × 4% = $1,200
* Estimated allowance = $700 + $1,200 = $1,900

If the existing allowance balance differs from the target, record bad debt expense for the difference.

Percentage-of-sales method

Apply a single historical percentage to period net sales to determine bad debt expense.

Example:
* Net sales $100,000 × 3% = $3,000 bad debt expense and an increase to allowance for doubtful accounts.

This method measures expense on the income statement; the allowance balance accumulates over periods.

Tax considerations

• The IRS allows businesses to deduct bad debts that were previously included in income or represent bona fide loans. For business bad debt deductions, the direct write-off method is often used for tax filing.
• Nonbusiness bad debt (personal loans not repaid) may be deductible as short‑term capital losses if the taxpayer can prove a true loan existed rather than a gift.
• Certain items (unpaid wages, rents, etc.) typically do not qualify as deductible bad debts.

Bad debt versus “good debt”

The term bad debt is also used more loosely to describe borrowing for items that don’t appreciate or produce income (consumer debt). This contrasts with “good debt,” which funds assets or investments expected to increase income or net worth.

Bottom line

Bad debt is an unavoidable cost when extending credit. For accurate financial reporting and compliance with the matching principle, companies generally estimate bad debt using the allowance method and disclose an allowance for doubtful accounts that offsets gross receivables. Regularly reviewing collection experience and aging schedules helps keep estimates reasonable and financial statements reliable.