How to Calculate and Record Provision for Bad Debts
It's September. Your balance sheet shows $28,000 in accounts receivable — money clients officially owe you. It looks like an asset. It feels like wealth. But three of those invoices are from people who haven't replied to a single email since July. Deep down, you know that money isn't coming. And yet it's sitting on your books as if it's real.
That gap between what you're owed on paper and what you'll actually collect in your bank account is exactly the problem a provision for bad debts exists to solve.
Ignoring it means your balance sheet is telling you a story that isn't true. Your assets are overstated. Your profits look healthier than they are. And one day — usually when a cash flow crisis arrives — reality corrects the picture painfully and all at once.
This guide shows you what the provision is, how to calculate it properly, how to record the journal entries, and — just as importantly — when to let go of an invoice and write it off completely.
- What Are Assets, Liabilities and Capital? A Plain English Guide — understand what accounts receivable is and why it's classified as an asset
- What Is a Ledger Account? How Businesses Track Every Transaction — how the provision account works as a contra-asset in your ledger
- How the Accounting Equation Keeps Your Books Balanced — why a provision affects both the P&L and the Balance Sheet simultaneously
What Is a Bad Debt Provision — and Why Does It Exist?
When you sell on credit — issuing invoices that clients pay later — you record the full amount as accounts receivable. Under the accounting equation, that's an asset, because someone owes you something of value.
But the accounting principle of prudence (also called conservatism) says you should never overstate your assets or your income. Experience tells us that a percentage of credit customers simply won't pay — due to cash flow problems, disputes, business failure, or in some cases, plain disappearance.
The provision for bad debts — also called the allowance for doubtful accounts — is an advance estimate of that uncollectable portion. You set it aside in the same period that you record the revenue. That way, your financial statements show a realistic picture of what you'll actually receive — not a fantasy figure.
Direct Write-Off Method — You wait until a debt is definitely uncollectable, then remove it and record a bad debt expense in that later period. Simple, but it violates the matching principle because the expense appears in a different period from the original sale. The IRS allows this for tax purposes, but it's not ideal for accurate financial reporting.
Allowance Method — You estimate bad debts at the end of each period and create the provision in advance, matching the expense to the same period as the revenue. Required under US GAAP for most businesses. This is the method we'll focus on — it's the one that tells the truth.
For a deeper understanding of how this entry flows through your records, see our guide to the books of original entry — the journals where this transaction first gets recorded before moving to your ledger accounts.
How to Calculate Your Bad Debt Provision
Method 1: Percentage of Credit Sales
Look at your historical data. If 2% of your credit sales have historically become uncollectable, apply that same rate to this period's sales. Straightforward, consistent, easy to defend to an auditor.
The weakness of this method: it doesn't look at individual invoices. It won't catch the situation where one large specific client is clearly heading toward non-payment while your overall average looks fine.
Method 2: Aging of Receivables (The Honest Method)
This is the more accurate — and more revealing — approach. You categorize every outstanding invoice by how overdue it is, then apply different bad debt rates based on age. The older the invoice, the lower the probability of collection.
| Invoice Age | Amount Outstanding ($) | Bad Debt Rate | Provision ($) |
|---|---|---|---|
| 0–30 days | $16,000 | 1% | $160 |
| 31–60 days | $6,500 | 5% | $325 |
| 61–90 days | $3,200 | 15% | $480 |
| 90+ days | $2,300 | 40% | $920 |
| Total | $28,000 | — | $1,885 |
Your receivables total $28,000 — but your realistic net collectible amount is $26,115. That's the honest number. That's what your balance sheet should show. Not $28,000.
The Journal Entries: How to Actually Record It
Understanding how ledger accounts work is essential here, because the provision uses a special type of account — a contra-asset — that sits opposite your receivables and directly reduces them on the balance sheet.
If you're not yet familiar with how debits and credits flow through these entries, our guide to debits and credits explained using T-accounts will make the journal entries below much clearer.
Step 1: Creating the Initial Provision
| Account | Debit ($) | Credit ($) | What This Does |
|---|---|---|---|
| Bad Debt Expense | 1,885 | — | Hits the P&L — reduces reported profit honestly |
| Provision for Bad Debts (Allowance) | — | 1,885 | Sits on Balance Sheet as contra-asset — reduces net receivables |
The Bad Debt Expense line reduces your net profit for the period on your Profit & Loss statement. The Provision account reduces your accounts receivable on the Balance Sheet — showing the realistic, net-collectible figure rather than the optimistic gross total.
This is the accounting equation working correctly: both sides are affected, both are telling the truth.
Step 2: Adjusting the Provision in Future Periods
At the end of the next period, you recalculate your aging schedule and compare it to your existing provision balance. You only record the difference — the increase or decrease needed to bring the provision to the correct level.
If the provision needs to increase (receivables are riskier than last period): debit Bad Debt Expense, credit Provision for Bad Debts — for the additional amount only.
If the provision needs to decrease (receivables are healthier, or debts were paid): debit Provision for Bad Debts, credit Bad Debt Expense — for the reduction amount only.
Step 3: Writing Off a Specific Bad Debt
When you finally accept that a specific invoice will never be paid — the client has vanished, gone into bankruptcy, or simply refused — you write it off. This is recorded in your books of original entry before posting to the ledger:
| Account | Debit ($) | Credit ($) | Why |
|---|---|---|---|
| Provision for Bad Debts | 500 | — | Uses up part of the allowance you already set aside |
| Accounts Receivable (specific debtor) | — | 500 | Removes the specific invoice from your receivables |
Recording a write-off as a brand new Bad Debt Expense when you've already created a provision for it. If you set up a $1,885 provision last period and now you're writing off a $500 invoice, the write-off goes against the provision — not against a new expense. Creating a second expense means you've charged the business twice for the same bad debt. Your profit takes the hit once (when the provision is created) — not twice.
This double-entry principle is the same one that runs through every transaction in your business. For a refresher on why every entry affects two accounts, see our guide on the double entry system made simple.
What Happens When a Written-Off Client Actually Pays?
It happens more often than you'd think. A client you wrote off six months ago emails you with a payment. Here's how to handle it:
Step 1 — Reinstate the debt: Debit Accounts Receivable $500, Credit Provision for Bad Debts $500. This reverses the write-off.
Step 2 — Record the payment: Debit Cash $500, Credit Accounts Receivable $500. Normal cash receipt entry.
The recovery is genuine value arriving in a period you didn't expect it — so it goes through properly, giving you a clear audit trail and keeping your books clean.
How the Provision Connects to Your Wider Accounting System
The provision for bad debts doesn't exist in isolation. It connects to — and affects — several other parts of your accounting system:
- Chart of Accounts — you need a properly set-up Provision for Bad Debts account as a contra-asset. See our guide on understanding the chart of accounts to make sure yours is structured correctly.
- Accounts Receivable Ledger — the individual customer records that sit behind your general receivables total. When you write off a specific debt, you're removing it from that customer's account. Our ledger account guide explains how this subsidiary ledger works.
- Bank Reconciliation — when a client finally pays, the cash receipt goes through your bank reconciliation. See how bank reconciliation works step by step to make sure payments are correctly matched.
- The Accounting Equation — creating a provision reduces both your assets (net receivables) and your equity (through reduced profit). It's a perfect example of how the accounting equation stays balanced even when the news is bad.
- Profit and Capital — bad debt expense reduces your net profit, which in turn reduces your capital/equity. If you're tracking how income and losses flow through to capital, see our article on how profit or loss affects capital in double entry accounting.
Alex runs a freelance UX design studio. In December, he runs his aging schedule and creates a $1,400 provision — three invoices are looking shaky based on the aging analysis. By February, one $600 invoice from a startup that went silent is confirmed gone. He writes it off against the provision. The remaining $800 provision carries forward to next period. His December P&L already absorbed the expense hit cleanly. His balance sheet has shown honest numbers throughout. No surprise write-offs. No ugly late P&L hits. No scrambling to explain the discrepancy to his accountant at tax time.
Many small business owners on accrual accounting record revenue when invoiced — which is correct — but then spend that money mentally as if it's already in the bank. It isn't. If you'd like to understand how stock, sales, and receivables all fit together, our guide on how to track stock and sales using simple accounting principles shows exactly how revenue flows from invoice to cash receipt.
VAT and Bad Debt Relief — Don't Leave Money on the Table
If your business is VAT-registered (or operates in a jurisdiction with sales tax), there's an additional consideration when writing off a bad debt. In many cases, you can claim back the VAT you already remitted to the tax authority on an invoice that was never paid.
This is called bad debt relief. The rules vary by jurisdiction, but in most cases the debt must be over a certain age (typically 6 months) and genuinely uncollectable. For a full explanation of how VAT works and when this applies, see our guide on VAT explained for small businesses.
Quick Reference Cheat Sheet
| Term | Plain English | Where It Appears |
|---|---|---|
| Bad Debt | Money a client owes you that they'll never pay | P&L as an expense |
| Provision for Bad Debts | Advance estimate of expected uncollectable invoices | Balance Sheet (contra-asset) |
| Aging Schedule | Grouping invoices by age to estimate collection risk | Management tool — drives the provision calculation |
| Write-Off | Removing a confirmed uncollectable invoice from your books | Against the provision, not a new P&L expense |
| Net Receivables | Total invoices owed minus the bad debt provision | Balance Sheet current assets section |
| Bad Debt Recovery | When a written-off client actually pays after all | Reversed write-off + cash receipt entry |
- What Is a Bad Debt? Definition, Examples and How to Spot One — Spot the warning signs before it hits your bottom line
- Bad Debt vs Doubtful Debt: What's the Difference? — the comparison every student and bookkeeper needs
- How to Write Off a Bad Debt: Step-by-Step Journal Entries — the practical how-to guide
- Bad Debt Recovery: What to Do When a Written-Off Client Pays — the reversal entry and why it matters
- Bad Debt Tax Deduction: Can You Claim It? — the US tax angle, accrual vs cash basis
🎯 Your Action for Today
Open your accounts receivable list right now. Sort every outstanding invoice by age. For anything over 60 days — be completely honest with yourself.
- Have you followed up in the last 2 weeks?
- Have you received a clear, committed response with a payment date?
- Should you be creating a provision — or actually writing something off?
Use the calculator above to run your aging schedule. Then post the provision journal entry in your accounting software this week — not next month.
Drop the age of your oldest uncollected invoice in the comments below. Let's talk honestly about what your options actually are — write-off, provision, or escalation.
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