Bad debt expense: Formulas, examples, and tax tips

If your business offers trade credit, you're bound to deal with unpaid invoices. When a customer fails to pay, you can write it off as a bad debt expense. But how you record that loss affects your financial reporting, tax deductions, and cash flow.

Here, we’ll break down what bad debt expense is, how to calculate it, and how to protect your business from the risk of uncollectible accounts. We'll also walk through journal entry examples, estimation methods, and tax implications so you can stay compliant with Generally Accepted Accounting Principles (GAAP) and make informed decisions.

What is bad debt expense?

Bad debt expense is the portion of accounts receivable that your company doesn't expect to collect. You record it as an operating expense on your income statement.

Businesses that extend credit to customers sometimes don't receive full payment. These uncollected amounts reduce both cash flow and net income. Recording these losses helps match revenue and expenses in the right accounting period, keeping your financial statements accurate.

Why bad debt expense matters

Bad debts affect more than just your balance sheet. When they’re not accounted for properly, they can lead to skewed performance metrics, missed forecasts, and poor decision-making. Regularly recording bad debt helps you stay ahead of cash flow issues and build more accurate budgets and projections.

Bad debt expense also plays a critical role in financial transparency and can affect your financial reporting. Investors, lenders, and stakeholders rely on clean financial statements to assess your company’s health. Overstating assets or income, even unintentionally, can hurt your credibility and make it harder to secure financing or favorable credit terms.

Recognizing bad debt expense helps:

• Improve financial reporting accuracy: Accurately reporting uncollectible accounts keeps both the income statement and balance sheet aligned with economic reality
• Forecast cash flow more realistically: Accounting for likely losses helps your business avoid overstating available funds and plan ahead for working capital needs
• Support compliance with GAAP: Properly recognizing bad debt helps satisfy GAAP, provided you calculate it using the allowance. More on that below.

How to calculate bad debt expense

There are two main methods to calculate bad debt expense: the direct write-off method and the allowance method. The best choice depends on your business size, industry, and accounting system. The allowance method is required under GAAP, but the direct write-off method is common among small businesses that use cash accounting.

Here are the steps to calculate bad debt expense:

1. Identify your accounts receivable balance: Start with your total outstanding credit sales, excluding any payments already received or adjustments already made
2. Choose a method: Select a calculation method based on your accounting framework. Use the allowance method for GAAP compliance or direct write-off for simpler, cash-based systems.
3. Estimate the uncollectible amount: Base your estimate on historical trends, aging reports, or a percentage of credit sales to reflect the true risk of non-payment
4. Record the expense using the selected method: Create the appropriate journal entry to update your bad debt expense and either reduce accounts receivable or adjust the allowance account

Using the direct write-off method

This method records bad debt only when a specific invoice is deemed uncollectible. It’s straightforward but doesn’t follow the expense recognition principle, which makes it non-compliant with GAAP.

Pros

• Simple to apply: You only need to act when a specific invoice is clearly uncollectible—no estimates or reserve tracking required
• Useful for small businesses with low risk of bad debt: Works well for companies with infrequent write-offs or those using cash-basis accounting

Cons

• May delay expense recognition: You might record the expense months after the related revenue, misaligning your financial results
• Can distort net income in the period of write-off: A large write-off could artificially reduce profit in a future period, even though the sale happened earlier

Example journal entry for direct write-off

A customer defaults on a $2,500 invoice. This reduces both your accounts receivable balance and net income:

Using the allowance method

The allowance method records estimated bad debt in the same period as the related revenue. It uses a contra account called allowance for doubtful accounts.

Pros

• Aligns with accrual accounting: The allowance method matches bad debt expense to the period when the related revenue is earned, providing a clearer view of profitability
• Complies with GAAP: The allowance method is required for businesses that follow GAAP, especially those that are audited or publicly traded
• Smooths earnings over time: Anticipating losses in advance helps avoid large one-time hits that could mislead stakeholders

Cons

• Requires estimation: You must regularly evaluate past data and payment trends to make informed assumptions about future losses
• Can lead to inaccuracies if historical data is flawed: Changes in customer behavior, credit policy, or economic conditions can make past loss rates unreliable
• Over- or underestimating the bad debt reserve: A reserve that's too high reduces current income unnecessarily; one that’s too low can lead to unpleasant surprises later

Example journal entry for allowance

You estimate that $6,000 of your accounts receivable may be uncollectible. This entry records the expense without touching specific customer balances. When you later write off an account, you debit the allowance account and credit accounts receivable:

Estimating bad debt: Formulas and best practices

There are two standard estimation methods: the percentage of sales method and the accounts receivable aging method. Here’s a closer look at both:

1. Percentage of sales method

This approach multiplies total credit sales by an estimated default rate.

Formula:

Bad Debt Expense = Total Credit Sales * Estimated %

Example:

Say your annual credit sales total $800,000, and 1.5% are expected to default. Using the formula above, here’s how you’d estimate your bad debt expense:

$800,000 * 0.015 = $12,000 bad debt expense

2. Accounts receivable aging method

This method applies different percentages to receivables based on how long they've been outstanding. It’s more precise but requires up-to-date records and analysis.

To calculate, run an AR aging report to group your receivables into 30-day increments based on how long they’ve been outstanding. Then, multiply the balance for each group by the percentage you estimate to be uncollectible:

Best practices for estimating bad debt

Use these practices to improve the accuracy of your estimates and reduce the risk of under- or overreporting bad debt:

• Review your accounts receivable aging schedule monthly: Frequent reviews help you catch emerging risks before they grow into write-offs, especially in volatile markets
• Adjust estimates based on current payment behavior: Don’t rely solely on historical percentages. Factor in recent trends like delayed payments or increased disputes.
• Watch for patterns of late payments or partial collections: Customers who consistently pay late or only in part may require closer monitoring or tighter credit terms

Tax and risk considerations

Understanding how bad debt affects your taxes—and how to reduce future risk—can strengthen both your short-term cash flow and long-term financial strategy.

In many cases, bad debt is tax-deductible. Refer to IRS guidance on bad debts, and consult a tax advisor to comply with your local regulations. But at its simplest, according to the IRS, you can deduct bad debts on your business tax return if:

• The amount was previously included in your income: You must have already reported the sale as revenue, typically under the accrual method of accounting
• You've made reasonable efforts to collect: Attempts may include invoices, follow-ups, collection agency contact, or legal action
• The debt is entirely or partially worthless: You don’t need to wait for bankruptcy, but you must demonstrate that further collection is unlikely

How to protect against bad debt

Here are some ways to reduce your risk of uncollectible receivables:

• Run credit checks before offering terms: Reviewing a customer’s credit history can help you identify risk before extending trade credit
• Set strict payment terms and monitor compliance: Clear due dates, early payment discounts, and late fees can encourage on-time payments
• Consider trade credit insurance: This coverage protects against losses from customer default and can improve credit confidence in uncertain markets
• Maintain a bad debt reserve, also known as the allowance for doubtful accounts: A well-calibrated reserve helps you absorb potential losses and keeps forecasts grounded in reality

Automated AR tools can help flag risky customers, track unpaid invoices, and streamline collections before debts become uncollectible.

Make your bad debt process part of a smarter close with Ramp

Missed payments and uncollected revenue can distort your financials, but the bigger risk is the time and effort it takes to track, estimate, and record bad debt manually. High-performing finance teams avoid that drag by building smarter workflows into their monthly close.

With Ramp’s accounting automation, you can streamline journal entries, auto-categorize expenses, and sync real-time data across your systems. That way, you’re not guessing what’s collectible or scrambling to reconcile later. That helps you stay GAAP-compliant, tighten forecasting, and reduce costly surprises.

When finance leaders automate key parts of the accounting cycle, they spend less time on clean-up and more time on strategic planning. Ramp helps you get there.