Bad debt expense: How to calculate and record it

When you sell a service or product, you expect your customers to fulfill their payment, even if it is a little past the invoice deadline. In a survey of small business owners, unpaid invoices resulted in more than $24,000 being owed to small businesses in 2024.

If your small business accepts credit sales, you run the risk of encountering something called a “bad debt expense.” Bad debt expenses are outstanding accounts that, after going unpaid, are deemed uncollectible.

In this post, we’ll further define bad debt expenses, show you how to calculate and record them, and more.

Jump to:

• Determining bad debt expenses
• How to calculate a bad debt expense
• Examples of recording bad debt expense journal entries
• Why bad debts happen
• How to prevent bad debts
• Choose the best payment setup for your business

Determining bad debt expenses

Every business has its own process for classifying outstanding accounts as bad debts. In general, the longer a customer prolongs their payment, the more likely they are to become a doubtful account. When your business decides to give up on an outstanding invoice, you’ll need to record the debt as an expense. 

Here’s how to determine bad debt expenses in your business:

• Choose your calculation method. There are two main ways to calculate bad debt expenses. We’ll discuss them in detail later.
• Choose your deadline. Invoices that haven’t been paid could become doubtful accounts. Think about how long you’re willing to give clients to pay what they owe. You’ll want to categorize any invoices still owed beyond that timeframe as doubtful accounts.
• Record your bad debt expenses. Use your calculation method to calculate your bad debt expenses and record that information in your journal entry.

Recording uncollectible debts will help keep your books balanced and give you a more accurate view of your accounts receivable balance, net income, and cash flow. We’ll show you how to record a journal entry for a bad debt expense a little later on in this post.

Is a bad debt expense an operating expense?

Typically, yes. These operating costs effectively reduce the amount of income your company brings in, and can be tracked under your administrative expenses.

Two ways to calculate a bad debt expense

Calculating bad debt expenses is an important part of business accounting principles. Not only does it parse out which invoices are collectible and uncollectible, but it also helps you generate accurate financial statements.

There’s more than one method to calculate bad debt expenses. Here are some ways to do it.

1. The write-off method

The direct write-off method is best for business owners whose customers typically fulfill their credit payments. This means you only have a few bad debts and don’t have to keep track of dozens of unpaid or past due invoices.

The process is straightforward and allows you to write off the value of those outstanding invoices from your total taxable income on a case-by-case basis. We’ll go over an example later.

2. The allowance method

The allowance method, also called the allowance for doubtful accounts, lets you preemptively label a certain portion of your total credit sales as doubtful debts. It functions under the assumption that at least some of your customers won’t pay the invoices you send. You effectively set aside money or create an allowance fund to help cover costs if your customers don’t pay invoices. 

It’s best for businesses that conduct most sales on credit and that are usually more likely to encounter bad debts. 

The bad debt expense formula

To estimate bad debts using the allowance method, you can use the bad debt formula. The formula uses historical data from previous bad debts to calculate your percentage of bad debts based on your total credit sales in a given accounting period.

Percentage of bad debt = total bad debts/total credit sales

Why should you calculate bad debt expenses?

Calculating bad debt expenses can help you save money when you file your taxes. The IRS often considers qualifying bad debt expenses as business expenses and may let you deduct those outstanding invoices from your total taxable business income.

Examples of recording bad debt expense journal entries

Recording bad debts is an important step in business bookkeeping and accounting. It’ll help keep your books balanced and give you realistic insight into your company’s accounts, allowing you to make better financial decisions. 

However, bad debt expenses only need to be recorded if you use accrual-based accounting. Most businesses use accrual accounting as it is recommended by Generally Accepted Accounting Principles (GAAP).

Businesses that use cash accounting principles never record the amount as incoming revenue to begin with, so you wouldn’t need to undo expected revenue when an outstanding payment becomes bad debt. In other words, there is nothing to undo or balance as bad debt if your business uses cash-based accounting.

With that said, here’s how to record a bad debt as a journal entry:

The direct write-off method

Creating a journal entry with the direct write-off method is simple. You’re identifying the invoices that are still unpaid on a case-by-case basis, meaning you only need to account for those exact invoices. 

Then debit the bad debt expense account and credit your accounts receivable in the journal entry.

Example:

Say you sold a customer $600 worth of office supplies, and they haven’t paid their invoice. With the direct write-off method, you’ll note the $600 as a bad debt expense in the debit column of your journal entry. Then, you’ll credit the $600 to the credit column for your accounts receivable.

The allowance method

To use the allowance method, record bad debts as a contra-asset account (an account that has a zero or negative balance) on your balance sheet. In this case, you would debit the bad debt expense and credit your allowance for bad debts.

Example:

Let’s say you’ve historically made 100,000 in credit sales in the past and have an average of $5,000 in unpaid credit sales each year. Using the bad debt formula, you can estimate your historical percentage of bad debt. 

Percentage of bad debt = 

$5,000 in unpaid credit sales / $100,000 in total credit sales

In this example, your percentage of bad debt comes to 5%. Say you’ve sold $20,000 of product. Using the percentage of bad debt allowance of 5%, you’ll want to budget $1,000 for bad debt expenses. 

You can add this to your journal entry by noting $1,000 in the debit column for your estimated bad debt expenses and $1,000 in your credit column to account for your bad debt allowance.

Bad debt expense on an income statement

Your business’s income statements help you track your income and expenses over a set period. Since bad debt expenses are typically classified as business expenses, you’ll want to account for those expenses on your income statements. Let’s take a look at a quick example.

Why bad debts happen

At a basic level, bad debts happen because customers cannot or will not agree to pay an outstanding invoice. This could be due to financial hardships, such as a customer filing for bankruptcy. It can also occur if there’s a disputed invoice or issues with the delivery of your product or service.

For example, if you complete a printing order for a customer, and they don’t like how it turned out, they may refuse to pay. After trying to negotiate and seek payment, this credit balance may eventually turn into a bad debt.

Bad debt expenses vs bad debt allowances

On the surface, bad debt expenses and bad debt allowances can seem very similar. However, they serve different purposes. 

Bad debt expenses are known losses. They’re outstanding invoices that you know won’t be paid. You have a set number (based on those outstanding invoices) that you can classify as a business expense.

Bad debt allowances are estimated losses. You’re estimating the amount of money you’ll likely lose over the course of a month, quarter, or year as a result of unpaid invoices. You then create an allowance based on that estimate and reduce the amount of money you expect to earn in sales by that amount.

How to prevent bad debts

If your business extends credit options to your customers, you will likely have to deal with bad debts eventually. Luckily, there are a few things you can do to prevent bad debts from happening in the first place:

• Establish a clear credit policy with payment expectations. Make these expectations known to your customers from the beginning and post those expectations on your website and in any sales agreement you make so customers are aware.
• Implement early payment discounts or late payment fees to encourage timely payment. Customers may be more likely to pay on time or early if they’re rewarded for positive actions and penalized for negative actions.
• Send automated invoice reminders with QuickBooks to follow up on outstanding balances. These reminders will hit your customers’ inboxes to remind them of any past-due invoices and may increase your percentage of invoices paid in the long run.
• Consider running credit checks before letting customers make purchases with credit. This lets you assess a customer’s creditworthiness to determine if they’re likely to pay you on time, if at all.
• Freeze customer accounts until they pay you what you’re owed. Don’t let customers with outstanding invoices make purchases on credit until they pay their outstanding invoices. This can prevent future bad debt expenses in the long run.

QuickBooks has a suite of customizable solutions to help your business streamline accounting. From insightful reporting to budgeting help and automated invoice processing, QuickBooks can help you get back to the daily tasks you love doing for your small business.

Choose the best payment setup for your business

Bad debts can interrupt your business’s cash flow, and while they’re typically tax-deductible, finding ways to reduce the risk of bad debt expenses can help your business thrive in the long run. Setting clear invoice payment terms and following up on late invoices can help you keep the money coming in.

QuickBooks lets you manage payments of all kinds in one central location and makes it easy for customers to pay what they owe in a way that works for them. Generate invoices, send reminders, and take the stress out of bookkeeping so you can grow your business.