Even companies diligent about performing credit checks on new customers can sometimes have trouble collecting accounts receivable. If it becomes clear that a customer either can’t or won’t pay an invoice, this results in a business bad debt.

What is bad debt, exactly?

The IRS defines a business bad debt as “a loss from the worthlessness of a debt that was either created or acquired in a trade or business or closely related to your trade or business when it became partly to totally worthless.”

There’s a potential silver lining to bad debts. In certain situations, you can deduct uncollected debts from your business income, which may reduce your tax liability, if the amount of the bad debt was previously included in your income.

This effectively means that only businesses that use accrual-basis accounting can deduct bad debts. Cash-basis businesses can’t deduct bad debts because they haven’t previously reported the debt as income. The IRS lists the following examples of business bad debts that may be deductible:

  • Credit sales to customers,
  • Loans to clients and suppliers, and
  • Business loan guarantees.

Bankruptcy is a common reason why a business might determine that an account receivable is uncollectible and should be written off. For example, suppose one of your customers files for bankruptcy and states that the liquidation value of its assets is less than the amount owed to its primary lien holder. Once the customer informs you that your receivable won’t be paid, you can generally write off the amount as a bad debt.

Business bad debts are deducted on Form 1040 Schedule C or on your applicable business income tax return.

Accounting for bad debt write-offs

From an accounting standpoint, there are two methods for writing off bad business debts:

With the direct write-off method, the receivable is written off against income after it’s determined that the account is uncollectible. This typically happens months after the receivable and credit sale have been recorded in your company’s books.

With the allowance method, you’ll anticipate in advance that some of your accounts receivable will be uncollectible. You’ll then debit bad debt expense and credit an allowance for doubtful accounts. The allowance account is used to report the net amount of receivables you expect to be converted into cash prior to identifying and removing any uncollected receivables.

Once a specific receivable is determined uncollectible, you’ll write it off with a credit to accounts receivable and a debit to an allowance for doubtful accounts. The allowance method adjusts accounts receivable on the balance sheet — no expense or loss is reported on the income statement.

Which method is best?

The direct write-off method is simpler than the allowance method, but there’s one major drawback: It violates the matching principle of accounting. In other words, this method recognizes bad debt expenses from a previous accounting period.

For example, if a credit sale was made at the end of 2015, the bad debt won’t be recognized until some time in 2016. In this scenario, expenses from a previous period would be deducted against revenue during a current period, which isn’t in accordance with Generally Accepted Accounting Principles.

Note: Generally, you must use the direct write-off method for income tax purposes, but you can use the allowance method for financial reporting purposes. Doing so will enable you to recognize the loss closer to the actual time of the credit sale. This will result in the bad debt expense being matched in the same accounting period as the credit sale itself.

The next step

Contact us more information on the implications of writing off bad debts.And find ways to reduce or eliminate bad debts.