What it means
A receivable is an asset because the business expects to collect it. When that expectation is gone, because the customer is insolvent, has disappeared, disputes the debt beyond recovery, or has simply not paid for so long that the chance of collection is remote, the asset must be removed.
Carrying uncollectible receivables overstates assets, overstates profit (since the loss has not been recognised) and misleads everyone who reads the balance sheet, including the business itself. Accounting anticipates the loss before it is confirmed.
Under current standards, businesses recognise an allowance for expected credit losses on their receivables and loans, estimated from historical experience and current conditions, and charge the expense as the allowance is built. The charge-off is the moment when a specific receivable is confirmed as lost: the balance is removed from receivables and the allowance is reduced by the same amount.
If the allowance was adequate, the charge-off has no further effect on profit; the expense was recognised when the allowance was raised. If the allowance was insufficient, the excess is charged to profit at the time of the charge-off.
Recoveries on charged-off debts, if they come, are credited back to the allowance or to income. For banks and consumer lenders, regulators prescribe when charge-off must occur: typically 120 days past due for closed-end consumer loans and 180 days for open-end credit such as credit cards in the United States, with bankruptcy triggering immediate charge-off.
The net charge-off rate (charge-offs less recoveries, as a percentage of average loans) is a primary indicator of portfolio quality, reported quarterly and compared with the allowance to test its adequacy. A charge-off does not release the borrower: collection continues internally or through sale to a debt buyer, and the debt remains on the borrower's credit record.
For other businesses, the decision is a judgement made by credit control and finance: the customer has entered insolvency proceedings; a collection agency has returned the account as uncollectible; legal action would cost more than the debt; or the account is beyond an age (often 12 months) at which the policy deems it lost. The write-off is documented, approved by someone with authority (and independent of the salesperson who owns the account, to prevent write-offs being used to conceal fraud), and recorded with the reason.
Tax rules generally allow a deduction for a bad debt once it is written off and the business can show it took reasonable steps to collect, which makes the documentation valuable. Charge-off statistics feed management.
A rising rate signals loosening credit standards, deteriorating customers or weak collection. A rate that is very low may mean credit is too tight and sales are being lost.
Analysis by customer type, sector, salesperson and age at write-off shows where the losses come from and what to change.
In practice
Real-world examples.
Example
A credit card issuer charges off accounts at 180 days past due, sells them to a debt buyer for 8 cents in the dollar, and records the proceeds as recoveries.
Example
A law firm writes off $60,000 of fees from a client that disputed the bill and has since been dissolved, after documenting three demands and the client's status.
Example
A utility writes off small balances under $50 that are more than a year old automatically, judging collection uneconomic, and reviews the total quarterly.
Think of it
“A charge off writes off a bad debt-removing an uncollectible amount from your books.
Formula
Calculation
Charge-off entry: Debit allowance for doubtful accounts (or bad debt expense if no allowance), Credit accounts receivable
Recovery entry: Debit cash, Credit allowance (or bad debt recovery income)
Net Charge-Off Rate (lenders) = (Charge-offs minus Recoveries) / Average loans outstanding x 100%
Bad Debt Rate = Amounts written off / Credit sales x 100%
Allowance Coverage = Allowance balance / Net charge-offs (years of losses covered)
Worked example 1, trade receivables. A wholesaler has trade receivables of $6,000,000 and an allowance for expected credit losses of $180,000 (3%). During the year:
- A customer owing $95,000 enters liquidation; the liquidator indicates a likely dividend of 10 cents in the dollar. The company writes off $85,500 (the 90% not expected) and keeps $9,500 as a receivable from the liquidator.
- Three small accounts totalling $22,000 are returned by the collection agency as uncollectible and written off.
- A $40,000 balance from a customer that closed its business with no assets is written off.
- Total charge-offs = $147,500. Entry: debit allowance $147,500, credit receivables $147,500.
- The allowance falls to $32,500. At year end, receivables are $6,400,000 and the expected loss rate, revised for the year's experience, is 3.5%: required allowance $224,000. Top-up expense = $224,000 minus $32,500 = $191,500, charged to profit.
- In the following year, the liquidator pays $12,000 (more than expected) and a customer written off two years ago pays $8,000 after a change of ownership. Recoveries of $20,000 are credited to the allowance.
Bad debt rate: credit sales $48,000,000; charge-offs $147,500; rate 0.31%. The company's policy target is under 0.4%. Analysis shows $107,500 of the $147,500 came from customers in one sector that had been granted terms above the standard; credit limits in that sector are reduced.
Worked example 2, a lender. A consumer lender has average loans of $500,000,000, an allowance of $18,000,000 (3.6%), and during the year charges off $14,000,000 of loans more than 180 days past due and recovers $2,500,000 on previously charged-off accounts.
- Net charge-offs = $11,500,000; net charge-off rate = 2.3%
- Allowance coverage before replenishment = $18,000,000 / $11,500,000 = 1.6 years
- The lender provides $13,000,000 of expense during the year, so the year-end allowance is $18,000,000 minus $14,000,000 + $2,500,000 + $13,000,000 = $19,500,000, or 3.9% of loans, reflecting a deteriorating outlook
- A regulator comparing the 2.3% net charge-off rate with the 1.6% of the prior year asks about origination standards; the lender's analysis shows the increase concentrated in loans originated during a growth push eighteen months earlier, and those criteria are tightenedCase study
Seen in the real world.
A building materials supplier had a bad debt rate of 0.2%, which its finance director cited as evidence of excellent credit control. An internal audit of write-offs found the real story. The credit manager, who was also responsible for approving write-offs, had a policy of never writing off any account, on the view that "we'll get it eventually".
The receivables ledger carried $1,100,000 of balances more than two years old, including $300,000 from companies that had been dissolved, and the allowance for doubtful accounts had not been reviewed for three years. The true bad debt rate, once the dead balances were written off, was 1.4% for the period concerned, and the write-off of $1,100,000 in a single year wiped out most of that year's profit, to the shareholders' surprise.
The auditors required a written charge-off policy: accounts in insolvency written off to the expected dividend on notification; accounts returned by agencies written off on return; balances over 12 months reviewed monthly and written off unless a documented recovery plan existed; write-offs approved by the finance director, not the credit manager; and the allowance reviewed quarterly against ageing and experience. The finance director's note to the board said the company's bad debts had not been low; they had been unrecorded.
Watch out
Common mistakes.
- Never writing off, which carries dead balances as assets, overstates profit and produces a shock when reality is finally recognised.
- Allowing the person who manages the customer relationship or the credit function to approve write-offs alone, which removes the check against write-offs concealing misapplied cash.
- Assuming a charge-off ends collection. The debt survives the accounting entry; collection, sale to a debt buyer or legal action may continue, and recoveries are income.
Questions
People also ask.
What is the difference between a charge-off and a write-off?
In substance none: both remove an uncollectible receivable from the books. Charge-off is the term used by banks and lenders, often with regulatory timing rules; write-off is general usage.
Does a charge-off affect profit?
Not if the allowance already covered the loss; the expense was recognised when the allowance was raised. If the allowance is insufficient, the shortfall is charged to profit at write-off.
When can a bad debt be deducted for tax?
Generally when it is written off in the books and the business can show the debt was genuine and reasonable collection efforts were made. Rules vary; documentation matters.
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