How to Calculate Bad Debt Expense in Financial Reporting

When customers fail to pay what they owe, the impact extends far beyond a few unpaid invoices. These uncollectible accounts can throw off your entire financial picture by distorting revenue, inflating assets, and masking the true cash flow of your business.

Bad debt expense represents the unavoidable cost of selling on credit when some receivables ultimately go unpaid.

Knowing how to calculate bad debt expense gives your company sharper forecasting, tighter financial controls, and fewer surprises during audits. It also ensures that you remain aligned with accounting standards, such as IFRS.

In this guide, we’ll walk through the methods, calculations, and journal entries used to recognize and manage bad debt, and explain how modern tools like Venn make this process smarter and simpler.

Why Tracking and Reporting Bad Debt Matters in Financial Statements

Bad debt expense is more than just a bookkeeping entry for Canadian companies, especially those offering net terms or operating with longer sales cycles. It plays a critical role in financial accuracy, regulatory compliance, and strategic decision-making. 

Here’s why it’s essential to track and report it properly:

1. Impacts Core Financial Statements

Failing to record bad debt inflates your accounts receivable and net income, which gives a misleading view of your financial health. Key metrics, such as DSO and ROA, appear stronger than they actually are. For instance, if there is a $30,000 unpaid invoice on the books, it inaccurately increases your assets and profitability.

2. Enhances Transparency and Stakeholder Trust

Lenders, auditors, and the CRA expect financial statements that accurately reflect actual collection performance. When bad debt goes unreported, it creates credibility gaps. Transparent reporting signals good governance and strengthens investor confidence.

3. Ensures Regulatory and Accounting Compliance

Both IFRS and ASPE require that expenses be matched to the revenue that generated them. Delaying the recognition of bad debt violates this principle. Recording it on time helps you stay compliant and avoid audit risks.

4. Informs Smarter Forecasting and Strategy

Tracking bad debt uncovers trends in customer payment behaviour and credit risk. This allows you to refine credit policies, adjust sales targets, and improve cash flow forecasting. Insights from write-offs lead to more realistic financial planning.

5. Keeps Cash Flow Projections Grounded

Unpaid invoices can give a false sense of liquidity if not accounted for. Estimating uncollectible receivables upfront keeps your forecasts aligned with reality to prevent overcommitting on staffing, inventory, or capital investments.

To keep your projections accurate, use this free cash flow calculator to identify how bad debt may impact your business liquidity.

Factors Influencing Bad Debt Estimation

Accurate bad debt estimation requires combining past data with forward-looking indicators, using a consistent, documented approach for reliable reporting and audit readiness. Here's what influences the calculation:

• Historical Write-Offs: Your baseline for estimating bad debt is influenced by historical write-off rates, which reflect the frequency of past customer non-payments.
  
• Economic Conditions: Your estimation is impacted by economic conditions and credit policies, as debts become harder to collect during recessions or periods of high inflation.
  
• Industry Norms: Extended receivables timelines in sectors such as construction and manufacturing make them more susceptible to bad debt.
  
• Credit Policy Strength: Loose approval terms increase default risk, while stricter credit policies help reduce exposure to doubtful accounts.
  
• Management Judgment: Always document past experiences and use consistent models, along with updated data, to ensure your allowance is reviewed periodically for accuracy.

Methods for Calculating Bad Debt Expense

The two primary methods for calculating bad debt expense are the Direct Write-Off Method and the Allowance Method. Smaller businesses with less frequent bad debts often use the direct write-off method, while larger companies with ongoing receivables rely on the allowance method. 

Both impact the income statement, and the choice depends on business size, accounting standards, and materiality.

Direct Write-Off

The direct write-off method is recognized when debts become uncollectible, meaning you record bad debt expense only after a specific account receivable is confirmed unpaid. It’s simple and requires no forecasting or estimation.

However, because the expense is recorded in a different period than the related revenue, it overstates profits early on and understates expenses later. This timing mismatch violates IFRS’s matching principle, reducing financial accuracy and period-to-period comparability.

For this reason, the direct write-off method is generally used by small businesses with infrequent bad debt. It’s not recommended for companies with regular receivables activity or audit-sensitive reporting needs.

Allowance Method

Assuming some customers won’t pay isn’t pessimism. It’s good accounting. That’s the idea behind the allowance method, which is used to account for uncollectible accounts in advance. Instead of waiting for a default, businesses estimate bad debt using predictive models and adjust their financials through a provision.

This method is applied to accounts receivable, creating an Allowance for Doubtful Accounts, a contra account that offsets receivables on the balance sheet. The estimate is influenced by credit risk factors, such as customer payment trends, economic forecasts, and collection history, and reflects the expected cost of future losses.

Here’s how to estimate under this method:

1. Percentage of Sales Method (Income Statement Approach)

Here, bad debt is calculated as a percentage of credit sales. If your past data shows that 1% of your credit sales go unpaid, apply that percentage to this period’s revenue. 

This is calculated based on sales history and is linked to the allowance for doubtful accounts. It's simple and ties neatly into revenue-based financial reporting.

2. Aging of Receivables Method (Balance Sheet Approach)

This model digs deeper. Receivables are grouped by age (e.g. 30, 60, 90+ days past due). Older accounts are considered higher risk, so higher percentages are applied.

This approach is based on the aging of receivables and is determined by analyzing aging schedules. It gives more accuracy but requires detailed accounting records.

Direct Write-Off vs. Allowance Method Comparison 

How to Calculate Bad Debt Expense: 3 Steps

Calculating bad debt expense doesn’t have to be complicated. Follow these three steps to maintain accurate financial records, support IFRS compliance, and enhance audit readiness and financial planning.

Step 1: Evaluate Previous Bad Debt Trends

Review historical write-offs, customer payment patterns, and collection rates over several reporting periods. If possible, group accounts by customer type, region, or credit terms to identify patterns and enhance forecast accuracy. This analysis forms the foundation for reliable, defensible estimates under IFRS’s Expected Credit Loss (ECL) model.

Step 2: Estimate Future Uncollectible Accounts

Choose a forecasting method that fits your business, either a flat percentage of total receivables or an aging schedule for more detailed analysis. Large companies that report under IFRS may be required to use a forward-looking Expected Credit Loss (ECL) model. 

When applying your estimate, remember to factor in the customer's payment history, credit risk, and prevailing macroeconomic conditions, as these will impact your collection outcomes.

Step 3: Record the Expense in Financial Books

Create a journal entry by debiting Bad Debt Expense and crediting Allowance for Doubtful Accounts. This step aligns expense recognition with the same period as the related revenue to ensure compliance with accrual accounting principles. Don’t forget to include supporting documentation to maintain a clear audit trail and reference in your financial statement notes.

How to Record Bad Debt Expense in Journal Entries

Once you've estimated your bad debt, the next step is to record it properly in your books. Both your income statement and balance sheet are affected by your journal entries. They also support compliance with IFRS while helping maintain clean audit trails. 

Recording Estimated Bad Debt Expense (Allowance Method)

Under the allowance method, you estimate future bad debt and record it in advance to align with IFRS requirements, specifically the Expected Credit Loss (ECL) model. This approach helps you anticipate losses before they occur, ensuring your financial statements remain accurate and compliant.

Journal Entry:

• Debit: Bad Debt Expense
• Credit: Allowance for Doubtful Accounts

This entry reflects the expected impact of uncollectible accounts and ensures your income statement and balance sheet remain aligned with accrual accounting standards.

Writing Off a Specific Uncollectible Account

You should remove a specific account receivable from your books once it is deemed uncollectible. Under the allowance method, you do this by debiting the Allowance for Doubtful Accounts and crediting Accounts Receivable.

Journal Entry:

• Debit: Allowance for Doubtful Accounts
• Credit: Accounts Receivable

The write-off simply adjusts the receivable balance, as the related expense has already been recognized.

Collection of a Previously Written-Off Account

If a customer unexpectedly pays an amount that was previously written off, you'll need to reverse the original write-off and properly record the incoming payment. Under the allowance method, this involves first reinstating the accounts receivable and then recording the cash collection.

Journal Entries:

1. Debit: Accounts Receivable
   Credit: Allowance for Doubtful Accounts
2. Debit: Cash
   Credit: Accounts Receivable

Recoveries like this improve financial clarity and, if significant, should be disclosed in the notes to your financial statements.

How to Calculate & Track Business Expenses with Venn

Venn helps Canadian businesses manage their expenses more efficiently with an all-in-one platform that offers real-time visibility, automation, and seamless accounting integration. Its expense management capabilities enable finance teams to streamline workflows, enforce controls, and eliminate manual bottlenecks.

With Venn, tracking receivables, forecasting costs, and organizing journal entries becomes simple, reducing the need for manual work. Venn's integration with QuickBooks and Xero helps keep your business data in sync and balance sheets accurate, so reconciliation is faster and less prone to errors.

Teams can easily track spending by department, region, or project using built-in analysis tools, credit balance tracking, and real-time budget controls. Whether you're managing local or global expenses, Venn provides real-time data flow and automated categorization to support quick decision-making and faster month-end closings.

Curious about what qualifies as a business expense? Learn how to write off your car as a business expense and start optimizing your deductions with confidence.

Best Practices to Improve and Avoid Bad Credit Expense

You can reduce bad debt expense through proactive credit management. When you manage credit risk effectively, you strengthen cash flow, improve reporting accuracy, and minimize costly write-offs.

Below are proven strategies to help you tighten financial controls, enhance forecasting, and protect your bottom line.

1. Review Allowance Balances Quarterly or Annually: Schedule quarterly or annual reviews of your allowance for doubtful accounts to ensure alignment with actual write-offs and current credit trends. Venn’s integration with QuickBooks and Xero helps track and sync transactions to minimize discrepancies and ensure accuracy.
   
   
2. Update Percentages Based on Collection Patterns: Use recent collection data to refine bad debt estimation percentages and avoid outdated figures that can provide inaccurate provisions and unexpected losses. With Venn’s real-time transaction tracking, it’s easier to spot trends in collection and adjust your estimates based on up-to-date data.
   
   
3. Consider External Factors (e.g., market downturns, client risk): Learn to adjust your estimates according to rising interest rates, layoffs, or sector-specific slowdowns that can impact customer behavior. Venn's multi-currency support and low-fee international payments help global companies mitigate risk, as Venn’s FX rates (ranging from 0.25% to 0.45%) are typically lower than those of traditional banks and other competitors.
   
   
4. Importance of Robust Credit Policies: Enhance your approval process by using clear credit checks, enforcing consistent terms, and screening high-risk customers before extending payment options. Venn helps you onboard the right customers by offering pre-authorization features and automated KYC (Know Your Customer) processes to assess customer creditworthiness.
   
   
5. Utilize Accounting Software: Use tools that automate receivables tracking, send reminders, flag overdue accounts, and support allowance and audit reporting. Venn's QuickBooks and Xero integration streamlines the process by syncing transactions and auto-categorizing payments, ensuring real-time, accurate accounts receivable and bad debt tracking.
   
   
6. Diversification of Customers: Avoid overreliance on a few large clients by diversifying credit across industries, customer sizes, and payment histories. Venn’s multi-currency accounts (USD, CAD, EUR, GBP) allow you to manage a diverse client base and handle payments in the right currency, without extra fees.
   
   
7. Discounts for Early Payment: Offer small discounts (e.g., 1–2%) for early payments to encourage faster settlements, which improve cash flow and reduce the likelihood of default. Automated invoicing in Venn's payment solutions simplifies customer payment tracking and discount offerings.
   
   
8. Seek Professional Advice: Consult a CPA or financial advisor if credit losses rise or IFRS compliance becomes complex, to keep your processes accurate and defensible. With Venn’s audit-ready reports, you can easily provide your CPA or financial advisor with the necessary data to ensure compliance and make informed decisions.
   
   

Key Takeaways

• Bad debt expense impacts your financial health by distorting key metrics, including assets, income, and DSO and ROA.
  
• Tracking and reporting bad debt ensures regulatory compliance, accurate forecasting, and improved transparency with stakeholders.
  
• The allowance method is the preferred approach for larger businesses, as it enables proactive estimation and better alignment with IFRS requirements.
  
• Proactive credit management and best practices, such as regular allowance reviews, tightening credit policies, and utilizing automated tools, help reduce write-offs and improve cash flow.

Ready to Take Control of Receivables and Reduce Bad Debt with Venn?

Venn gives you real-time visibility, automated journal entries, and seamless accounting integration to manage bad debt with ease. Stay audit-ready and in control with smarter financial tools.

Learn How Venn Helps You Manage Receivables Smarter

Frequently Asked Questions

Q. Is bad debt expense a tax-deductible item?

A. Yes, but only under certain conditions. In most jurisdictions, bad debt expense is tax-deductible if it’s been previously included in taxable income and is written off using the direct write-off method. Deductions for estimates under the allowance method are typically not allowed unless they meet specific criteria set by tax authorities.

Q. Does bad debt expense affect a company's cash flow?

A. No, it does not directly affect cash flow. While bad debt expense reduces net income, it’s a non-cash expense, meaning it doesn’t reduce actual cash on hand. Its primary impact is on the income statement, not your bank balance.

Q. When should you recognize bad debt expense?

A. Under the direct write-off method, you recognize bad debt expense only when a specific account is confirmed uncollectible. With the allowance method, the allowance is recorded in advance, during the same period as the related sale, to comply with accrual accounting and ensure proper revenue and expense matching.

Q. Can bad debt expense be reversed?

A. Yes, if a previously written-off account is recovered. In such cases, you must reverse the write-off entry and record the incoming payment, which updates your financial statements without affecting net income a second time.

Q. How do large companies handle bad debt differently from small businesses?

A. Larger companies use more sophisticated tools such as aging schedules, predictive analytics, and detailed segmentation to estimate and manage bad debt more precisely. Small businesses often rely on flat percentages or simpler methods, due to fewer resources and lower transaction volumes.

Q. How does IFRS handle bad debt expense?

A. IFRS 9 requires companies to apply the Expected Credit Loss (ECL) model. This means bad debt must be estimated and recorded in advance, based on the likelihood of default, instead of waiting for an account to become uncollectible.

Q. What happens if a previously written-off account is collected?

A. You must first reverse the original write-off by reinstating the receivable, then record the cash receipt. If the recovery is material, it should also be disclosed in your financial statement notes for transparency.