Bad Debt Expense 101: Learn how to Calculate, Track, & Improve

Bad debt expense is an inevitable challenge for many businesses, especially those offering credit terms. When customers fail to pay, it not only impacts your revenue but also distorts your financial projections. Understanding bad debt expense—how to calculate it, track it, and minimize its impact—is key to protecting your cash flow.

In this guide, we’ll cover the essentials of bad debt expense and provide practical steps to reduce its effect on your business, ensuring stronger financial stability.

So, what is a Bad Debt Expense?

Bad debt expense—what it really means—is the cash that you have invoiced for (the accounts receivable) your business doesn't collect. It represents those customers that, for one reason or another, won't be paying what they owe. Under both GAAP and IFRS, bad debt is recorded when a business decides that an invoice will not be paid—either because of customer default or because the business has decided it is uncollectible.

The industries most affected

Bad debt particularly occurs in industries like B2B services, retail, and construction, where lengthened credit terms are extended to customers. 

For instance, a retail supplier who offers Net 30 payment terms (e.g. they have 30 days to pay) may learn over time that a segment of customers simply never pay their invoices. Without proper planning, that is a surefire way to get into cash flow trouble.

Bad debt is less about lost revenue and more about risk mitigation. Noting it down and being able to account for it early will protect your financial health.

How Bad Debt is treated in your part of the world

Bad debt treatment varies significantly across different countries, reflecting diverse accounting standards and tax regulations.

How Bad Debt is treated in the United States

‍In the USA, bad debt treatment is governed by the Internal Revenue Service (IRS):

• Businesses can deduct bad debts when they become worthless, using either the specific charge-off method or the nonaccrual-experience method.
• For tax purposes, bad debts must be genuinely uncollectible and previously included in income.
• Businesses must demonstrate that reasonable steps were taken to collect the debt.
• The IRS allows businesses to deduct partial bad debts if they can prove that a portion of the debt is worthless.
• Bad debt deductions are typically taken on Schedule C for sole proprietorships or Form 1120 for corporations.

Learn more about how the IRS treats Bad Debt directly on their website.

How Bad Debt is treated in the United Kingdom

‍In the UK, bad debt relief is governed by HM Revenue & Customs (HMRC). Businesses can claim relief on VAT previously paid on supplies that have become bad debts. Key points include:

• The debt must be more than 6 months old but less than 4 years and 6 months old.
• The business must have written off the debt in their VAT accounts.
• For partial payments, businesses can claim relief on the unpaid portion.

Learn more about how HM Revenue & Customs (HMRC) treats Bad Debt more in depth in their manual here.

How Bad Debt is treated in the European Union

‍The EU's approach to bad debts is outlined in the VAT Directive (2006/112/EC). Member states have some flexibility in implementing these rules:

• Most EU countries allow businesses to reclaim VAT on bad debts.
• The timeframe for claiming relief varies by country (e.g., 12 months in France, 6 months in Germany).
• Some countries require businesses to prove they've taken reasonable steps to recover the debt.

Learn more about VAT Directive (2006/112/EC) here.

How Bad Debt is treated in Canada

‍The Canada Revenue Agency (CRA) allows businesses to claim a deduction or an allowable business investment loss (ABIL) for bad debts:

• Bad debts must be genuinely uncollectible and written off in the company's books.
• For GST/HST purposes, businesses can claim a deduction for the tax portion of bad debts.
• The CRA requires businesses to keep detailed records of collection efforts.

Learn more about how Canada Revenue Agency (CRA) treats Bad Debt on their website.

How Bad Debt is treated in Australia

‍The Australian Taxation Office (ATO) provides guidelines for bad debt deductions:

• Bad debts can be claimed as a tax deduction if they were previously included as assessable income and written off as bad in the same income year.
• The debt must be genuinely bad, not merely doubtful.
• For GST purposes, businesses can claim a decreasing adjustment for the GST they've paid on bad debts.
• There's no specific time limit for writing off a debt, but the business must keep records to show why the debt is considered bad.
• If a written-off debt is later recovered, it must be included as income in the year it's received.

Learn more about how the Australian Taxation Office (ATO) treats Bad Debt on their website.

How Bad Debt is treated in New Zealand

In New Zealand, bad debt treatment is overseen by the Inland Revenue Department (IRD):

• Businesses can claim a deduction for bad debts that are written off as bad in their accounts.
• The debt must be genuinely bad and written off before the end of the income year.
• For GST-registered businesses, a GST adjustment can be claimed on bad debts written off.
• There's no set time frame for writing off a debt, but businesses must be able to show that the debt is unlikely to be recovered.
• If a bad debt is later recovered, it must be included as income in the tax return for that year.
• Specific rules apply for financial arrangements, which may allow for a bad debt deduction even if the debt hasn't been written off.

Learn more about how the Inland Revenue Department (IRD) handles Bad Debt here.

Why Bad Debt Tracking is so important

Ignoring bad debt doesn’t make it disappear; it only worsens cash flow problems. Here’s why tracking bad debt expense should be a top priority:

Cash Flow Optimization: Bad debt uses up precious resources that would have otherwise been invested in the expansion of an enterprise. A report by the FSB in 2022 showed that over 50% of all small businesses suffered from late payments, and some sectors were as high as a 64% jump in overdue invoices. The more delayed cash is, the greater the financial burden and stress it places on trying to manage daily activities.

Profitability and growth: Correctly gauging bad debt means one does not overestimate revenue or income, which may result in distorted profit forecasts that hurt long-term growth.

Risk Management: Monitoring the AR metrics will enable you to highlight problem areas—specific clients or sectors where the compensation is always late or forever coming. In this regard, you readjust your terms or policy before it is too late.

The 2 Methods for Calculating Bad Debt Expense

Now that you understand why you need to track, let's discuss how to calculate bad debt expense.

1. Direct Write-Off Method: This is the easiest method: when a debt is confirmed to be uncollectible, you write it off as an expense. It's easy but not good for future planning, as it doesn't follow GAAP. In this method, income tends to get overstated in earlier periods.

2. Provision for Doubtful Accounts: A more sophisticated approach is setting up an Allowance for Doubtful Accounts, where you will estimate the future bad debts based on past experience or the industry average. That way, it allows for a truer representation of receivables on your balance sheet.

Pro tip: You might want to use data analytics or machine learning models for fine-tuning an estimate. AI can help predict bad debt by analyzing client payment patterns along with other risk factors​.

Calculating Your Allowance for Doubtful Accounts: If you have $100,000 in receivables and expect that 5% may go uncollected, you would record:

• Debit: Bad Debt Expense $5,000
• Credit: Doubtful Accounts Allowance $5,000

This approach smooths your financial statements and gives a clearer view of what's really at risk.

Best Practices for recording Bad Debt

Whether you are a financial genius or are new to accounting, it could be straightforward to record bad debt if set up correctly.

Here's a step-by-step breakdown:

1. Record your Bad Debt Expense: Record an expense for the amount you have estimated that you will not collect in your accounting system.

2. Adjust your AR balance: Reduce your accounts receivable account by the amount of the bad debt.

3. Automate it with Accounting Software: Applications like Xero and QuickBooks have in-built features to identify and capture bad debt lists with minimal manual interference.

How you can minimize Bad Debt and improve your AR Management

Bad debt decreases with good AR management practices. Here are some actionable steps you can implement right now:

Automate your AR processes: A tool like Paidnice would enable you to automate reminders for payment, automatically apply late fees, and even manage escalations. Each of these automation processes keeps you away from having to manually chase overdue invoices, hence reducing your workload and the chances of bad debt piling up​.

Evaluate the Creditworthiness of the Client: Before extending credit, it's paramount to check the status of one's credit. Do this with your localized credit reporting bureau for a real-time look into the risk profile of your clients​.

Create a Dynamic Credit Policy: Your credit policy should reflect the prevailing economic circumstances. Continuous focus on customer payment experience and general trends in your industry will form the basis of decisions regarding when credit terms or incentives, such as early payment discounts, should be tightened or extended.

Make it easy, automate your account recievable with technology

Automation is the game-changer in AR management. If one has the right set of tools, then one will be able to save hours of manual work and minimum human error and thus avoid big bad debt altogether.

Simple technology that can reduce your Bad Debt Expense:

• Email & SMS Reminders: Send reminders automatically linked to due dates on invoices or behaviors from the client.
• Automation of late fees: Configuration of rules that automatically trigger late fees as soon as a payment deadline has passed.
• Personalized Client Communication: You can apply tools like Paidnice to personalize how you broadcast your message and automatically follow through to clients based on their history​.

Best of all, these systems integrate with such accounting software as Xero and QuickBooks—so your records stay updated in real time, without you having to lift a finger.

Proactive AR Management is the key to avoiding Bad Debt

Bad debt is an inevitable part of doing business, but it can be avoided or minimized. Secondly, in order to reduce bad debts, automation tools for strong AR management do provide a solution to this particular challenge. One such tool is Paidnice. By using it, you will be able to enhance your cash flow and truly focus on the core aspect of your business: growing your company.

Ready to disrupt your accounts receivable process? Book a demo of Paidnice today and see just how easy it is to automate your way to healthier cash flow.