Bad debt expense is the cost of customer invoices a business does not expect to collect. It is recorded as an operating expense on the income statement, and it reduces accounts receivable, either directly when a specific invoice is written off or through an allowance estimated in advance.
Bad debt expense: definition, methods and examples
By The AR Agent team · · 7 min read
What is bad debt expense?
When you invoice on credit, you record the sale and an amount in accounts receivable. Some of those invoices never get paid. The money you will not get is bad debt, and recording it as a cost is bad debt expense.
The IRS says business bad debts mainly result from credit sales to customers, and the uncollectible part of your receivables is a business bad debt.
Direct write-off method vs allowance method
The direct write-off method is simpler and is what most small businesses and US tax returns use. The allowance method is what accrual financial statements prepared under US GAAP normally use, because it matches the cost to the period of the sale.
The direct write-off method
Under the direct write-off method, nothing happens until you decide a particular invoice will not be paid. Then you remove it from AR and record the expense.
Say a contractor invoiced a customer $3,200 in May. By November the customer has closed down and stopped answering. The contractor writes the invoice off:
| Account | Debit | Credit |
|---|---|---|
| Bad debt expense | $3,200 | |
| Accounts receivable | $3,200 |
It is simple. Its weakness is timing: the expense lands in November, though the sale was recorded in May.
The allowance method
Under the allowance method, you estimate at the end of each period how much of your receivables will not be collected, and expense that estimate straight away. It sits in an allowance for doubtful accounts, which reduces AR on the balance sheet.
A common approach applies a loss rate to each age bucket on your accounts receivable aging report. Say a business has $120,000 of receivables at year end:
| Age | Balance | Estimated loss rate | Allowance needed |
|---|---|---|---|
| Not yet due | $90,000 | 1% | $900 |
| 1 to 60 days past due | $20,000 | 5% | $1,000 |
| More than 60 days past due | $10,000 | 20% | $2,000 |
| Total | $120,000 | $3,900 |
The rates here are invented for illustration. Real ones come from your own collection history.
If the allowance already has a $1,400 balance from earlier periods, the business only records the difference:
| Account | Debit | Credit |
|---|---|---|
| Bad debt expense | $2,500 | |
| Allowance for doubtful accounts | $2,500 |
Later, when a specific $1,800 invoice is confirmed as uncollectible, it is written off against the allowance, not as a new expense:
| Account | Debit | Credit |
|---|---|---|
| Allowance for doubtful accounts | $1,800 | |
| Accounts receivable | $1,800 |
The expense was already recognized in the estimate.
Where does bad debt expense show on the income statement?
Bad debt expense is an operating expense, usually listed with selling, general and administrative costs. It reduces operating profit for the period in which it is recorded. That is why the allowance method gives a truer picture: the cost of selling on credit lands in the same period as the sales.
It is not deducted from revenue, unlike a credit memo, which reduces sales because you have agreed the customer owes less. With bad debt, the customer still owes the money.
How are bad debts treated for US tax?
This is general information about US federal income tax, not tax advice.
- Business bad debts are deductible. Section 166 of the Internal Revenue Code allows a deduction for a debt that becomes worthless during the year, and a partial deduction for one recoverable only in part.
- The amount must have been in income first. The IRS allows the deduction only if the amount owed was included in gross income that year or earlier. So a cash-method business generally cannot deduct an unpaid invoice it never reported as income.
- Most businesses must use the specific charge-off method. The IRS says that generally you must use it, deducting specific debts as they become partly or totally worthless. For a partly worthless debt, the deduction is limited to the amount charged off on your books that year. The reserve method was repealed in 1986, so an allowance estimate on your books is generally not what you deduct.
- Showing a debt is worthless. The IRS says you must only show that you have taken reasonable steps to collect the debt and were unable to do so. A record of your follow-up is useful evidence.
Sole proprietors claim business bad debts on Schedule C (Form 1040). The IRS's bad debts material, formerly in Publication 535, is now in chapter 8 of Publication 334.
How does faster follow-up reduce bad debt expense?
Bad debt is usually an invoice that was late, then later, then forgotten. A few habits keep invoices out of the oldest buckets:
- Follow up the day after the due date, not weeks later. A collections email sequence makes this routine.
- Find the blocker early. A missing PO can stall an invoice for months.
- Get a date, not a promise, and follow up the day after if it does not arrive.
- Agree a structure when a customer cannot pay in full. A payment plan agreement can recover more than a write-off.
Frequently asked questions
What is the difference between bad debt expense and the allowance for doubtful accounts?
Bad debt expense is the cost recorded on the income statement for a period. The allowance for doubtful accounts is a balance sheet account that holds the running estimate of receivables you do not expect to collect. Recording bad debt expense under the allowance method increases the allowance.
Can a cash-basis business deduct bad debts?
Generally not for unpaid customer invoices. The IRS allows a bad debt deduction only for amounts already included in gross income. A cash-method business records income when it is paid, so an invoice that was never paid was never counted as income, and there is nothing to deduct.
When should a business write off a bad debt?
When there is no longer a realistic chance it will be paid. For US tax, the IRS says you need to show you took reasonable steps to collect and could not. A clear record of every follow-up email helps show that, and writing an invoice off does not stop you collecting it later.
Does writing off a bad debt mean the customer no longer owes it?
No. A write-off changes your records, not the customer's obligation. If the customer later pays, you record the payment. For US tax, you may need to include the recovery in income, up to the amount you deducted. Our guide to collecting unpaid invoices covers what to try before writing anything off.
How The AR Agent handles this
Bad debt usually starts as an invoice nobody followed up in time. The AR Agent follows up overdue invoices by email, at the right time for each customer, using the due dates in QuickBooks or Xero. It reads replies, turns "we'll pay next week" into a tracked payment promise, and follows up if the date passes. It identifies common blockers, such as a missing PO or the wrong contact, before an invoice drifts into the oldest aging bucket. When a customer disputes an invoice, it pauses normal chasing and brings in the right person. Every email, promise and action is kept on record.
Talk to us: our AI agent chases your invoices until you are paid.
Sources
- Definition of a business bad debt, the requirement that the amount was included in gross income, the cash-method limit, and the pointers to Schedule C and Publication 334 (IRS Topic 453) -> https://www.irs.gov/taxtopics/tc453
- Bad debts mainly result from credit sales; specific charge-off method generally required; partly worthless debts limited to the amount charged off; reasonable steps to collect; recoveries included in income up to the amount deducted; Publication 535 material moved to chapter 8 (IRS Publication 334, 2025) -> https://www.irs.gov/publications/p334
- Deduction for wholly and partially worthless debts, and repeal of the reserve for bad debts by Pub. L. 99-514 (26 U.S.C. 166) -> https://www.law.cornell.edu/uscode/text/26/166