Bad Debt Expense: A B2B Guide to Accounting, Management & Prevention 

Extending credit to customers is a necessary part of doing business, but it comes with the inherent risk that some invoices will never be paid. When an account receivable becomes uncollectible, it becomes a bad debt, and it must be accounted for on your income statement as a bad debt expense. 

This expense directly reduces your profitability and impacts your cash flow. Effectively managing and protecting your business against bad debt expense is therefore crucial for your financial health. This guide covers how to account for, manage, and ultimately, insure against this critical business cost. 

Bad debt is a receivable that is no longer deemed recoverable because the customer is unable or unwilling to pay. This can happen for many reasons: 

• Customer Insolvency or Bankruptcy: The most common reason. 
• Severe Cash Flow Problems: Your customer's own clients may be paying them late. 
• Disputes or Fraud: Disagreements over the goods/service or deliberate credit fraud. 
• Market Downturns: A sudden economic shift can impact a previously healthy customer. 

The first warning sign of a potential bad debt is a late payment. Proactive management at this stage is critical. 

Correctly recording bad debt expense is essential for accurate financial reporting. There are two primary methods: 

1. The Direct Write-Off Method 

This method is used when a specific invoice is identified as uncollectible. The amount is "written off" directly as an expense. 

• Process: When you are certain a specific debt is irrecoverable, you debit the bad debt expense and credit the accounts receivable account. 
• Journal Entry Example: Debit: Bad Debt Expense $5,000 Credit: Accounts Receivable $5,000 
• Note: This method is simple but doesn't align with the matching principle of GAAP, as the expense may be recorded in a different period from the revenue. It is more common under IFRS for specific write-offs. 

2. The Allowance (Provision) Method 

This is the preferred method under GAAP. It involves estimating future bad debts and creating a provision (or allowance) for them in the same period the sales are made. 

• Process: You estimate a percentage of your total credit sales that you expect will become bad debt. This amount is recorded as an expense, and credited to a contra-asset account called "Allowance for Doubtful Accounts." 
• Journal Entry Example (to create the allowance): Debit: Bad Debt Expense $10,000 Credit: Allowance for Doubtful Accounts $10,000 
• When a specific invoice is later identified as uncollectible, it's written off against this allowance, not as a new expense. 

Tax Implications of Bad Debts 

In many jurisdictions, you can reclaim VAT or sales tax that you have already paid on sales that later become bad debts. This "bad debt relief" is an important mechanism, but the specific rules and timeframes vary significantly by country. 

While some bad debt is inevitable, you can take internal measures to minimize it: 

1. Proactive Credit Management 

Implement sound credit control policies. This includes conducting thorough credit checks on new customers, setting appropriate credit limits, and having clear, enforceable payment terms in your contracts. 

2. The Bad Debt Letter & Collections Process 

When an invoice becomes overdue, act quickly. 

• Send a Reminder: A polite initial reminder can often resolve simple oversights. 
• Escalate Communication: If payment is still not made, send a more formal "bad debt letter" (or demand letter). It should be concise, state the facts (invoice number, amount, due date), and clearly outline the next steps and a final deadline. 
• Maintain Professionalism: The goal is to collect the debt while, if possible, maintaining the customer relationship. 

Internal controls can reduce risk, but they cannot eliminate it. A large, unexpected customer failure can create a significant spike in bad debt expense, severely damaging your profitability. 

Bad debt insurance—also known as non-payment insurance or Trade Credit Insurance (TCI)—is the most effective way to transfer this risk. 

How TCI Transforms Bad Debt Expense from a Risk to a Manageable Cost 

Instead of facing unpredictable and potentially catastrophic bad debt losses, TCI converts that risk into a predictable, budgeted premium. 

• Protection: If an insured customer fails to pay due to insolvency or other covered reasons, your TCI policy compensates your company, typically for up to 90% of the debt. This directly protects your P&L and cash flow. 
• Prevention: Bad debt insurance from Allianz Trade is more than just a safety net. We provide powerful credit intelligence and ongoing monitoring of your customers. These insights help you make better-informed credit decisions and avoid high-risk sales in the first place. 
• Recovery: Our global network of debt collection experts can help recover outstanding payments efficiently and professionally, often preserving the customer relationship. 

What is the Cost of Bad Debt Insurance? 

The premium is generally calculated based on your turnover and the risk profile of your customer portfolio and industry. For a company with an annual turnover of €10 million in a low-risk market, the cost can be around €1,500 per month. This cost should be weighed against the potential for a single large bad debt to wipe out a significant portion of your profits. 

Bad debt expense is a direct hit to your company's bottom line. A comprehensive strategy to manage it involves a multi-pronged approach: accurate accounting, proactive internal credit management, and strategic risk transfer. By combining sound internal controls with the robust protection of bad debt insurance, you can turn a volatile financial risk into a manageable and predictable business cost, giving you the confidence to trade and grow securely. 

Ready to protect your business from the impact of bad debt expense? Contact an Allianz Trade expert today.