What it means
Every business that extends credit takes the risk that some customers will not pay. A small proportion of bad debt is normal and is priced into the margin; a large or rising proportion means credit is being granted too freely, collections are too slow, or the customer base is deteriorating.
The distinction between doubtful and bad matters: a doubtful debt is one the business expects it may not collect and provides against; a bad debt is one it has decided it will not collect and writes off. The accounting depends on whether an allowance exists.
Under the allowance method, which accounting standards require for businesses with material receivables, the expected losses are estimated and charged to expense in advance, and a specific write-off is simply a transfer within the balance sheet: debit allowance, credit receivables, with no further effect on profit. Under the direct write-off method, used by very small businesses and for tax in some jurisdictions, the loss is charged to expense only when the debt is written off, which delays the recognition of losses and mismatches them with the sales that caused them.
Writing off a debt does not mean abandoning it. Businesses continue to pursue written-off debts through collection agencies, legal action or insolvency claims, and any recovery is recorded as income when received.
Nor does it affect the customer's legal obligation. The write-off is an accounting judgement that the asset is no longer worth carrying, not a release of the debt.
Bad debt is managed before it happens. Credit checks and limits, clear terms, prompt invoicing, systematic collections and early escalation reduce the amount that becomes bad.
Credit insurance can transfer the risk of large customer failures. For businesses with many small customers, statistical models predict which accounts will default and adjust terms accordingly.
The bad debt rate, tracked monthly against credit sales and analysed by customer type and salesperson, shows whether these controls are working.
In practice
Real-world examples.
Example
A telecoms company writes off 2.2% of consumer billings each year as bad debt and builds the rate into its pricing.
Example
A construction subcontractor writes off $400,000 when a main contractor collapses, and thereafter takes credit insurance on any contract over $100,000.
Example
A freelance designer writes off a $3,000 invoice from a client who has stopped responding, and records the recovery when a collection agency obtains $1,800 a year later.
Think of it
“Bad debt is like the money you know you'll never see again after lending to an unreliable friend. You have to accept the loss.
Formula
Calculation
Bad Debt Rate = Bad Debts Written Off in the period / Credit Sales in the period x 100%
Write-off entry under the allowance method: Debit Allowance for Doubtful Accounts, Credit Accounts Receivable
Recovery entry: Debit Cash, Credit Bad Debt Recovered (income) or Credit Allowance
Worked example. A distributor of catering equipment has annual credit sales of $12,000,000. During the year it identified the following debts as uncollectable:
- A restaurant group that entered liquidation owing $85,000; the liquidator estimates a 5% dividend
- A hotel that closed owing $22,000, with no assets
- Fourteen small accounts totalling $31,000, each more than 12 months overdue after repeated demands
- Total written off = $138,000
The allowance for doubtful accounts at the start of the year was $120,000, built from the aging analysis.
- Write-off entry: debit allowance $138,000, credit receivables $138,000
- The allowance is now negative by $18,000, so the year-end reassessment must rebuild it; if the aging at year end requires an allowance of $130,000, the bad debt expense for the year is $130,000 + $18,000 = $148,000
Bad debt rate = $138,000 / $12,000,000 = 1.15%
Later the liquidator pays $4,250 (5% of $85,000) on the restaurant group's debt. Entry: debit cash $4,250, credit bad debt recovered $4,250.
Prevention test: the restaurant group's balance had grown from $30,000 to $85,000 over four months while its payments slowed from 45 to 90 days. A credit limit of $40,000 with supply on hold above it would have capped the loss at less than half. The distributor introduces limits reviewed quarterly.Case study
Seen in the real world.
A regional building supplies merchant had a bad debt rate of 0.4% for years, then saw it jump to 2.8% in a single year when three builders failed within months of each other, costing $520,000. The finance director's review found that all three had shown the same warning signs: payment days lengthening, round-sum part payments, requests for higher limits, and rumours in the trade. The merchant's credit process had consisted of an opening credit check and nothing after.
The company introduced monthly monitoring of every account over $20,000 (payment days, balance trend, credit agency alerts), a rule that any account exceeding its limit or 60 days goes on stop until reviewed, and credit insurance on its 30 largest accounts. The following year bad debts fell to 0.5%, and the insurer paid out on one failure that the monitoring had flagged three months earlier, by which time the balance had been halved.
Watch out
Common mistakes.
- Waiting until a debt is hopeless before recognising the loss. The allowance should reflect expected losses as they become likely, not certain.
- Stopping collection efforts when a debt is written off. Recoveries on written-off debts are common and are pure income.
- Blaming bad debts on customers alone. Most large bad debts follow warning signs that credit control could have acted on.
Questions
People also ask.
What is the difference between bad debt and doubtful debt?
Doubtful debt is expected to be partly or wholly uncollectable and is provided against. Bad debt has been judged uncollectable and is written off.
Is bad debt tax deductible?
Generally yes, once the debt is written off and the business can show it took reasonable steps to collect, but rules vary by jurisdiction and some require specific evidence.
What is a normal bad debt rate?
Below 1% of credit sales for most business-to-business companies with sound credit control; higher in consumer credit and in industries with fragile customers such as construction and hospitality.
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