What are bad debt expenses?

What are bad debts?

A bad debt arises when accounts receivable or other amounts owed to your business become uncollectible. For example, if you extend credit to a customer and they default, the unpaid amount becomes a bad debt. Recognizing bad debt helps maintain accurate financial records by showing the true value of expected income.

How to categorize bad debts

• Record under Operating Expenses on your income statement.
• Use a “Bad Debt Expense” or “Uncollectible Accounts” account in your chart of accounts.
• Reduce Accounts Receivable by the same amount when writing off the debt.
• Use the allowance method to estimate potential bad debts (GAAP preferred) or the direct write-off method for simpler accounting.
• Only record a bad debt once all reasonable collection efforts have been made.

Examples of bad debts

• Unpaid customer invoices after multiple collection attempts.
• Loans or advances to clients or vendors that won’t be repaid.
• Returned checks that cannot be recovered.
• Credit sales written off due to bankruptcy or customer insolvency.
• Uncollectible rent or service fees.

Tax implications for bad debts

• Bad debts from business transactions are tax-deductible as ordinary business expenses.
• To qualify, the amount must have previously been included as income or recorded as receivables.
• Personal bad debts (money loaned to friends or family) are not deductible as business expenses.
• For accrual-basis taxpayers, bad debts are deducted when written off; for cash-basis taxpayers, they’re generally not deductible since income wasn’t yet recorded.
• Keep documentation of invoices, collection efforts, and communications to substantiate the deduction.
• Report business bad debts on Schedule C (for sole proprietors) or the appropriate line on your business tax return.