What is Bad Debt in Business?

How a receivable becomes a bad debt
The two ways to record bad debt

Bad debt is money customers owe you that you won't collect. The open textbook Principles of Accounting, Volume 1: Financial Accounting from OpenStax defines bad debts as "uncollectible amounts from customer accounts." In the books, a business records bad debt in one of two ways: the allowance method, which estimates it in the period of the sale, or the direct write-off method, which records it when a specific customer's account is found to be uncollectible. For US tax purposes, the IRS has its own rules, quoted below.

Billed publishes this page. The accounting definitions are quoted from OpenStax chapter 9, Accounting for Receivables, and the US tax rules from IRS Topic 453; both were opened on October 30, 2026. For receivables in general, see what is accounts receivable. For the same unpaid invoice seen from both sides, see what is a business claim.

How a receivable becomes a bad debt

You sell on credit, the customer doesn't pay, and after you've followed up, it becomes clear the money isn't coming. The customer's business may have closed, the customer may dispute the work, or they may stop responding. OpenStax says: "When future collection of receivables cannot be reasonably assumed, recognizing this potential nonpayment is required."

Before that point, an unpaid invoice is still a receivable you're trying to collect. See how to follow up on unpaid invoices.

The two ways to record bad debt

OpenStax says: "There are two methods a company may use to recognize bad debt: the direct write-off method and the allowance method."

Direct write-off method: it "delays recognition of bad debt until the specific customer accounts receivable is identified." Once an account is uncollectible, the company records "a reduction to the customer's accounts receivable and an increase to bad debt expense for the exact amount uncollectible." OpenStax adds: "Under generally accepted accounting principles (GAAP), the direct write-off method is not an acceptable method of recording bad debts, because it violates the matching principle." It notes an exception for "entities that rarely offer credit to its customers."
Allowance method: it "estimates bad debt during a period, based on certain computational approaches." OpenStax says "The estimation is made from past experience and industry standards." The estimate goes into an allowance for doubtful accounts, which OpenStax's chapter 9 key terms define as a "contra asset account that is specifically contrary to accounts receivable; it is used to estimate bad debt when the specific customer is unknown."

Under the allowance method, accounts receivable minus the allowance gives the net realizable value, the "amount of an account balance that is expected to be collected." OpenStax adds that the company "will still try to collect the entire" amount it's owed.

If a written-off customer pays later: OpenStax says the first entry "reverses the previous entry where bad debt was written off," and the second "records the payment on the account."

The impact on your business

Cash: the money you expected doesn't arrive, though the work or goods were delivered.
Profit: bad debt expense reduces net income, under either method.
Assets: accounts receivable on the balance sheet falls to what you expect to collect.

The methods differ in timing. The allowance method puts the expense in the period of the sale; the direct write-off method puts it in the period you identify the loss.

Sample: the allowance method, entry by entry

The business and figures here are a sample, invented for this example.

A design studio has $40,000.00 in accounts receivable at December 31. From its own collection history, it estimates that $1,200.00 of that won't be collected.

December 31, record the estimate: debit Bad Debt Expense $1,200.00; credit Allowance for Doubtful Accounts $1,200.00.
- Net realizable value: $40,000.00 − $1,200.00 = $38,800.00
March 15, a $700.00 invoice is found to be uncollectible: debit Allowance for Doubtful Accounts $700.00; credit Accounts Receivable $700.00.
- Accounts receivable: $40,000.00 − $700.00 = $39,300.00
- Allowance: $1,200.00 − $700.00 = $500.00
- Net realizable value: $39,300.00 − $500.00 = $38,800.00, unchanged, because the loss was already estimated in December.

Each entry has equal debits and credits. Under the direct write-off method, there would be no December entry. On March 15, the studio would debit Bad Debt Expense $700.00 and credit Accounts Receivable $700.00, so the expense would fall in the new year rather than the year of the sale.

US tax treatment (IRS)

IRS Topic no. 453, Bad debt deduction ("Page Last Reviewed or Updated: 24-Sep-2026", opened October 30, 2026) says:

"Generally, to deduct a bad debt, you must have previously included the amount in your income or loaned out your cash."
"If you're a cash method taxpayer (most individuals are), you generally can't take a bad debt deduction for unpaid salaries, wages, rents, fees, interests, dividends, and similar items of taxable income."
"You may deduct business bad debts, in full or in part, only if the amount you were owed is included in your gross income in the current or prior year."
"To show that a debt is worthless, you must establish that you've taken reasonable steps to collect the debt."
"You may take the deduction only in the year the debt becomes worthless."

For how the cash and accrual methods report income, see cash vs accrual accounting. Ask your accountant how these rules apply to your business.

Prevention strategies

None of these steps makes a customer pay. They help you decide who gets credit, limit how much is outstanding, and spot late accounts sooner:

Check a new customer before you extend credit, especially for a large first order.
Put the terms in writing before the work starts: the due date, how to pay, and what happens if payment is late. See late payment policies and invoice payment terms explained.
Ask for a deposit on large jobs, so less is outstanding if the customer doesn't pay. See the guide to deposit invoicing.
Invoice promptly and follow up on a schedule. See how to follow up on unpaid invoices.
Review your receivables by age so overdue accounts stand out. See the accounts receivable aging report.

Where Billed fits

Billed's invoice software page says: "Invoice reports show which invoices are paid, partially paid or past due, and you can see who owes you money and send them a payment reminder. Payment reminders can be customized."

Frequently Asked Questions

What is bad debt in business?

Money customers owe that won't be collected. OpenStax defines bad debts as "uncollectible amounts from customer accounts."

What is the difference between the allowance method and the direct write-off method?

The allowance method estimates bad debt in the period of the sale and records it in an allowance for doubtful accounts. The direct write-off method records bad debt expense only when a specific customer's account is found to be uncollectible. OpenStax says the direct write-off method isn't acceptable under GAAP because it violates the matching principle. Its exception is for "companies with very little exposure to the possibility of bad debts, typically, entities that rarely offer credit to its customers": "Assuming that credit is not a significant component of its sales, these sellers can also use the direct write-off method."

Can a small business deduct bad debt in the US?

It depends on how you report income. IRS Topic 453 says: "If you're a cash method taxpayer (most individuals are), you generally can't take a bad debt deduction for unpaid salaries, wages, rents, fees, interests, dividends, and similar items of taxable income." Ask your accountant how this applies to you.

What happens if a customer pays after the debt was written off?

Under the allowance method, OpenStax describes two entries: the first reverses the write-off, and the second records the payment.

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Bad Debt in Business: Causes, Impact & Prevention