# Bad debt: the allowance, the write-off and the tax return

> Northwind's allowance from its year-end aging, the write-off when a customer fails, why the tax return waits for the write-off, and how a credit note, a refund and a write-off differ.

Source: https://lopifi.com/learn/bad-debt-allowance-vs-direct-write-off
Part of: Lopifi — US GAAP books on autopilot, checked by a CPA (https://lopifi.com)

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**How do I account for a customer who won't pay: allowance or direct write-off?** Northwind's allowance from its year-end aging, the write-off when a customer fails, why the tax return waits for the write-off, and how a credit note, a refund and a write-off differ.

Some customers won't pay. US GAAP asks you to say so before it happens. Northwind's September close booked an [allowance for credit losses](https://lopifi.com/md/glossary/allowance-for-credit-losses) of $160 on a receivable nobody was late on (AJE-5, from [the adjusting entries lesson](https://lopifi.com/md/learn/adjusting-entries)). That's the [current expected credit loss](https://lopifi.com/md/glossary/cecl) model: expected losses over a receivable's life, from the day it's booked.

*[Journal entries: AJE-5]*

September's estimate.

## December 31: the allowance from the aging

ASC 326 doesn't prescribe a method. An aging schedule with a loss rate per bucket is one the standard names. Northwind's rates are its own estimate, built from what its trade loses and adjusted for what it knows about its customers. Older buckets carry more.

> “The allowance for credit losses may be determined using various methods. For example, an entity may use discounted cash flow methods, loss-rate methods, roll-rate methods, probability-of-default methods, or methods that utilize an aging schedule.”

© Financial Accounting Foundation. All rights reserved.

— [ASC 326-20-30-3](https://asc.fasb.org/326/tableOfContent), An aging schedule is an accepted way to estimate the allowance

| Bucket | Open | Loss rate | Expected loss |
| --- | --- | --- | --- |
| Current | 9,000 | 1% | 90 |
| 1–30 | 5,500 | 3% | 165 |
| 31–60 | 6,000 | 10% | 600 |
| 61–90 | 2,400 | 25% | 600 |
| 91+ | 0 | 50% | 0 |
| Total | 22,900 |  | 1,455 |

The allowance required at December 31, 2026.

The allowance already holds $160, so the entry is the difference: $1,295 of [bad debt expense](https://lopifi.com/md/glossary/bad-debt-expense). Net receivables on the balance sheet are $21,445. For the year, bad debt expense is $1,455, and not one invoice has been written off.

> **A practical expedient from 2026.** ASU 2025-05 lets any company estimating losses on current receivables assume that conditions at the balance sheet date don't change for the rest of the receivable's life, so there's no economic forecast to build. A company that isn't a public business entity and elects it may also take into account what it collected after year end. It's effective for annual periods beginning after December 15, 2025.

> “For assets described in paragraph 326-20-30-10A, an entity may elect a practical expedient to assume that current conditions as of the balance sheet date do not change for the remaining life of the asset.”

© Financial Accounting Foundation. All rights reserved.

— [ASC 326-20-30-10C (ASU 2025-05)](https://asc.fasb.org/326/tableOfContent), A practical expedient for the allowance on current receivables

## January: Kestrel goes under

In January 2027 Kestrel Fitouts files for bankruptcy and Northwind expects nothing from its $2,400 invoice. It's [written off](https://lopifi.com/md/glossary/write-off) against the allowance. Both lines are on the balance sheet, so the write-off doesn't touch profit. The loss was expensed when it was expected.

— [ASC 326-20-35-8](https://asc.fasb.org/326/tableOfContent), Write-offs come out of the allowance; recoveries are recorded when received

The allowance held $1,455 for the whole book and Kestrel alone took $2,400, so it's now $945 short. Nothing is restated. The next estimate tops the allowance back up, and the shortfall reaches expense in the period the estimate changed. If the trustee later pays something, that's a [recovery](https://lopifi.com/md/glossary/bad-debt-recovery): reinstate the receivable against the allowance, then apply the cash.

**Allowance method**
- Pro: The loss lands in the period of the sale
- Pro: Receivables shown at what's expected to be collected
- Con: An estimate to make and defend every period
- Con: Its own schedule to keep
- Best for: US GAAP statements: an audit, a lender, a priced round

**Direct write-off**
- Pro: No estimate
- Pro: Matches how the tax deduction works
- Con: Not GAAP where expected losses are material
- Con: Overstates receivables until the customer fails
- Best for: The tax return, and books where losses are immaterial

The two methods.

The tax return doesn't follow the allowance. Federal tax deducts a bad debt only in the year a specific debt becomes worthless, so Northwind's book expense and its deduction land in different years. The page below works it.

## Credit note, refund or write-off

|  | What it says | Entry |
| --- | --- | --- |
| [Credit note](https://lopifi.com/md/glossary/credit-note) | The customer doesn't owe it | Dr revenue or contra-revenue (and sales tax payable), Cr AR |
| [Refund](https://lopifi.com/md/glossary/refund) | Cash goes back to the customer | Dr AR or a refund liability, Cr cash |
| [Write-off](https://lopifi.com/md/glossary/write-off) | They owe it and won't pay | Dr allowance for credit losses, Cr AR |

Three different things that all make a receivable smaller.

## Pages in this lesson

- [The tax deduction for bad debts](https://lopifi.com/md/learn/bad-debt-allowance-vs-direct-write-off/bad-debt-tax-deduction) — 5 min. When can a business deduct bad debt on its tax return?

## Where this lesson's rules come from

- [ASC 326-20-30-1](https://asc.fasb.org/326/tableOfContent) — The allowance presents receivables at the amount expected to be collected (codification)
- [ASC 326-20-30-3](https://asc.fasb.org/326/tableOfContent) — An aging schedule is an accepted way to estimate the allowance (codification)
- [ASC 326-20-35-8](https://asc.fasb.org/326/tableOfContent) — Write-offs come out of the allowance; recoveries are recorded when received (codification)
- [ASC 326-20-30-10C (ASU 2025-05)](https://asc.fasb.org/326/tableOfContent) — A practical expedient for the allowance on current receivables (codification)
- [ASC 606-10-32-10](https://asc.fasb.org/606/tableOfContent) — Cash expected to be refunded is a refund liability, not revenue (codification)
- [Wikipedia, “Bad debt”](https://en.wikipedia.org/wiki/Bad_debt) — Bad debt (reference)
- [Wikipedia, “Credit note”](https://en.wikipedia.org/wiki/Credit_note) — Credit note (reference)

## Read further

- https://lopifi.com/md/journal-entries/bad-debt-expense
- https://lopifi.com/md/journal-entries/write-off-accounts-receivable
- https://lopifi.com/md/journal-entries/customer-refund
- https://lopifi.com/md/differences/bad-debt-expense-vs-write-off
- https://lopifi.com/md/startups/bad-debt-and-write-offs
- https://lopifi.com/md/accounting/asc-326
- https://lopifi.com/md/docs/domain/05-order-to-cash

- **Track:** [Accounts receivable](https://lopifi.com/md/learn/ar)
- **Lesson:** Lesson 8 of 9 — 10 min
- **Terms taught:** [Allowance for credit losses](https://lopifi.com/md/glossary/allowance-for-credit-losses), [CECL](https://lopifi.com/md/glossary/cecl), [Bad debt expense](https://lopifi.com/md/glossary/bad-debt-expense), [Write-off](https://lopifi.com/md/glossary/write-off), [Direct write-off method](https://lopifi.com/md/glossary/direct-write-off-method), [Bad debt recovery](https://lopifi.com/md/glossary/bad-debt-recovery), [Credit note](https://lopifi.com/md/glossary/credit-note), [Refund](https://lopifi.com/md/glossary/refund)
- **Previous:** [DSO and CEI, worked, AR · Lesson 7](https://lopifi.com/md/learn/ar-aging-report-dso-cei/dso-and-cei)
- **Next:** [The tax deduction for bad debts](https://lopifi.com/md/learn/bad-debt-allowance-vs-direct-write-off/bad-debt-tax-deduction)
- **The course:** https://lopifi.com/md/learn