Bad debt and write-offs: what to do when a customer won’t pay

01Two methods, two purposes#

Under the direct write-off method, nothing happens until a specific invoice is given up on; then it is written off straight to bad debt expense. It is simple and it is how tax works. Its flaw for financial statements is timing: the sale was recognized in one period and the loss lands in another, sometimes a year later, so receivables are overstated in between.

Under the allowance method, you estimate at each balance sheet date how much of today’s receivables won’t be collected and hold that estimate as an allowance for credit losses, a contra-asset netted against accounts receivable. Receivables appear at what you expect to collect, and the expense lands in the period that made the sale. That is what US GAAP requires. For a company whose bad debts are genuinely immaterial, the two methods give nearly the same numbers, which is why many very small companies use the direct method in practice and the reviewer accepts it. Once receivables are material, expect to need an allowance.

02The GAAP rule: ASC 326#

The standard is ASC 326, the current expected credit loss model, usually called CECL. It applies to trade receivables and to contract assets under ASC 606, not only to bank loans, and it has applied to private companies for fiscal years beginning after December 15, 2022. It asks for an estimate of losses expected over the life of the receivable, starting from historical loss experience, adjusted for current conditions and for reasonable forecasts.

For a startup’s receivables, which mostly turn into cash within a few months, that usually becomes a simple matrix: a loss rate for each aging bucket, taken from your own history or a reasonable proxy, applied to the balances, plus a specific reserve for any customer you know is in trouble. In 2025 the FASB added a practical expedient for current receivables and contract assets (ASU 2025-05): a company may assume that conditions at the balance sheet date don’t change over the asset’s remaining life, and a private company that uses it may also elect to consider cash collected after the balance sheet date when making the estimate. It is effective for annual periods beginning after December 15, 2025, with early adoption permitted. Whether to elect it is a policy choice to make with your CPA, and the election is disclosed.

03The allowance, worked#

Use an aging of $138,000: $84,000 current, $31,500 at 1–30 days, $12,000 at 31–60, $6,000 at 61–90 and $4,500 over 90. Suppose your history supports loss rates of 0.5%, 2%, 5%, 15% and 50%. The expected losses are $420, $630, $600, $900 and $2,250: an allowance of $4,800. The rates are illustrative; yours come from your own collections.

If the allowance stood at $3,000 last quarter, the adjustment is $1,800. On the debit side, bad debt expense (or credit loss expense) $1,800; on the credit side, allowance for credit losses $1,800. The balance sheet now shows accounts receivable of $138,000 less an allowance of $4,800: $133,200 net. Nothing has been written off yet, and nothing has been said to any customer.

04Writing off an invoice, and getting the money back#

When a specific invoice is uncollectible, the customer has gone out of business, the debt is past any realistic chance, or it costs more to chase than it is worth, write it off against the allowance. A $2,000 invoice: debit allowance for credit losses $2,000, credit accounts receivable $2,000. The income statement doesn’t move, because the expense was already recognized when the allowance was built. Record why, who approved it, and keep the collection history.

Sometimes the money comes back. Reverse the write-off, then record the payment: debit accounts receivable $2,000, credit allowance for credit losses $2,000; then debit cash $2,000, credit accounts receivable $2,000. The customer’s history now shows both events, which is what you want when they ask for terms again.

Under the direct write-off method the same invoice is simply debit bad debt expense $2,000, credit accounts receivable $2,000, and a recovery reverses it: debit accounts receivable, credit bad debt expense (or other income, if the write-off was in a prior year), then record the cash.

05The tax side#

For federal income tax, most businesses deduct bad debts under Internal Revenue Code section 166 using the specific charge-off method: the deduction is taken when a particular debt becomes worthless, not when you estimate a reserve. The reserve method for general businesses was repealed by the Tax Reform Act of 1986. So the GAAP allowance and the tax deduction will usually differ at any date, and that difference is expected. Sales tax is separate again: many states let you recover tax you remitted on an invoice that proves uncollectible, each with its own rules for timing and proof.

In outline, the federal deduction works like this:

• The debt must be a real one you included in income, which rules out cash-basis taxpayers’ unpaid invoices.
• It must be wholly or partly worthless in the year you deduct it, with evidence: collection attempts, a bankruptcy notice, a closed business.
• You must have charged it off in your books, not merely reserved for it.
• A later recovery is generally income, to the extent the earlier deduction reduced your tax.

06Don’t use a write-off for something else#

A write-off is for a customer who owes the money and won’t pay. It is not for a customer who was billed wrongly, given a discount, or promised a credit: those are credit notes, and they reduce revenue rather than adding to credit losses. Mixing the two makes revenue look higher than it was and loss history look worse, and it is exactly the kind of thing a CPA review or a diligence team finds in the first hour.

Set a small threshold below which an unpaid residue, a few dollars of a short payment, can be written off without approval, and require a named approver above it. Every write-off needs a reason and an account, so a year from now someone can tell a dead customer from a pricing concession.