Bad Debt: An Expense Entrepreneurs Can’t Afford to Overlook
Bad Debt: An Expense Entrepreneurs Can’t Afford to Overlook
Bad debt is rarely random. It stems from identifiable breakdowns: fraud, weak processes, external shocks, or unresolved disputes. This guide outlines where bad debt comes from, how to address it at the source, and how to manage it strategically through accounting, forecasting, and write-offs.
Bad debt is rarely random. It stems from identifiable breakdowns: fraud, weak processes, external shocks, or unresolved disputes. This guide outlines where bad debt comes from, how to address it at the source, and how to manage it strategically through accounting, forecasting, and write-offs.
Market Adaptation Strategies
May 15, 2025
Turns out even biblical kings knew to write off bad debt before year-end (Matthew 18:21–35)
The Parable of the Unmerciful Servant, Jan Senders van Hemessen, 1556
As decision makers, you navigate complex financial landscapes where every line item impacts strategic decisions. While bad debt may seem like a routine accounting matter, it’s a powerful lever that, when managed effectively, can enhance financial clarity, optimize tax efficiency, and strengthen investor confidence. Knowing how to handle bad debt is crucial and the answer lies in seeing bad debt also as a tool, not a mere accounting footnote.
Choosing the right accounting method
There are two basic approaches on how to account for bad debt: Direct write-off and allowance method. Nevertheless, the choice is pivotal:
Direct Write-Off: Simple, but delays risk recognition and lacks GAAP compliance. Suitable only for very early-stage businesses with minimal credit exposure.
Allowance Method: Estimates future losses, providing a forward-looking view crucial for forecasting and robust financial reporting. It's essential for scaling businesses with recurring credit sales.
Implement the allowance method and update it quarterly, leveraging tools like HighRadius or BlackLine for automation and risk scoring. This ensures accurate, timely financial insights.
Understanding where bad debt comes from
Bad debt doesn’t just appear on your books but builds over time through specific patterns: late-paying customers, weak follow-up processes, or poorly structured sales terms. It also reveals business side of the story: how your business qualifies clients, sets incentives, and enforces discipline. In most cases, bad debt can be traced to one of four scenarios:
1. Fraud
This occurs when the customer never intended to pay. Common examples include fake identities, shell entities, or fraudulent transactions. These are hard to recover and typically indicate weak onboarding or insufficient credit checks.
2. Insufficient processes
Sometimes, the issue lies internally. Invoices are not chased, reminders are missed, or there is no clear ownership of collections. These failures turn manageable delays into permanent losses.
3. External shocks
Customers may default due to reasons outside their control - economic downturns, bankruptcies, currency risk, or geopolitical instability. These cases can’t be prevented but should be anticipated and factored into risk planning.
4. Disputes or dissatisfaction
Not all non-payment is financial. In some cases, customers withhold payment due to insufficient value delivery such asservice issues, product defects, or contract disputes. If these cases aren’t addressed early, they often end up as write-offs.
Identifying which of these scenarios is driving bad debt helps companies take more targeted action; whether that means improving credit vetting, tightening internal workflows, or closing feedback loops between departments.
Mitigating Bad Debt at the Source
Once the cause of bad debt is understood, it becomes easier to manage. The goal isn’t just to reduce write-offs—it’s to build systems that prevent them from happening. Each type of bad debt requires a different response.
Fraud mitigation
Fraudulent debt can’t be recovered, so the focus should be on prevention. Most fraud happens during onboarding or the first transaction, before credit risk even reaches finance.
Use fraud detection tools that flag high-risk behavior in real time. Platforms like SEON, Stripe Radar, or Riskified help identify red flags such as mismatched billing information, unverifiable domains, and rapid purchase activity. Combine these with basic checks like company registry validation, VAT number lookups, and conservative credit limits for first-time clients.
Process mitigation
Bad debt caused by internal process failures—missed reminders, unclear ownership, or lack of escalation—is common in growth-stage companies.
Establish structured dunning processes: automated, time-based reminders that escalate in tone and urgency. Assign clear responsibility for collections within the finance team and track key indicators such as Days Sales Outstanding (DSO), recovery rates, and aging trends. Ensure that collections are embedded in weekly operational routines, not treated as a reactive task.
External risk mitigation
Economic events or sector-specific disruptions can cause even strong customers to default. These shocks are outside your control, but exposure to them can be managed.
Track receivables concentration by geography, industry, and customer size. Apply credit limits in higher-risk segments and consider credit insurance where exposure is significant. For companies reporting under IFRS, maintain a provision buffer for receivables linked to sectors or regions under pressure.
Dispute mitigation
Payment delays driven by dissatisfaction often go unnoticed until they become write-offs. These cases are typically caused by gaps in service delivery, product quality, or expectation management.
Make disputed invoices visible in your ERP or CRM. Connect finance with customer success and account management to surface issues early. Track recurring problems like late deliveries or contract misunderstandings and feed them back into process improvements. Ensure that disputes are not only resolved but systematically reduced over time.
Tax Deductibility: What qualifies and why it matters
Once bad debt is identified - whether through aging analysis, dispute resolution, or fraud detection - the next step is understanding its financial implications. Beyond risk mitigation, bad debt write-offs play a direct role in shaping your tax position and year-end financial reporting. But for it to be deductible, it must meet certain conditions:
The revenue was previously recognized
The debt is wholly or partially worthless
Collection efforts are documented
The write-off is recorded in the correct fiscal year
Partial write-offs are allowed if properly supported. This matters especially for high-value receivables where partial recovery may still be possible.
Strategic Insight: Review aged receivables before year-end. Well-timed write-offs reduce tax exposure and improve your balance sheet ahead of audits or fundraising.
Strategic use of write-offs
Write-offs are often seen as reactive. But when used intentionally, they become a financial planning tool.
In high-income years, they can reduce tax liabilities. In investor or audit cycles, they help present a cleaner balance sheet. Bad debt is part of doing business when you sell on credit. But when unmanaged, it clouds your forecasts, weakens your margins, and sends the wrong signal to stakeholders.
Handled strategically, it becomes a source of control. It enables better reporting, sharper tax positioning, stronger investor confidence, and clearer operational decisions.
For growing companies, managing bad debt well is more than hygiene—it’s a hallmark of financial maturity.
Citations:
https://www.semanticscholar.org/paper/5d2c52ce5d8a23f57d598b184c3a708b34e91594
https://www.semanticscholar.org/paper/091d04812a5f25b872232e1c8c731a77f7d43bc5
https://www.semanticscholar.org/paper/1a872e062b0f0ee38fc73ac695e2e582a3878da0
https://www.semanticscholar.org/paper/552dd675f8f26d45ef07db5f3085da324d2eac9b
https://finance.cornell.edu/accounting/topics/revenueclass/baddebt
https://pro.bloombergtax.com/insights/federal-tax/deducting-business-bad-debt/
https://www.myob.com/au/resources/guides/accounting/bad-debt
https://blog.taxact.com/tax-deductions-non-business-bad-debts/
Turns out even biblical kings knew to write off bad debt before year-end (Matthew 18:21–35)
The Parable of the Unmerciful Servant, Jan Senders van Hemessen, 1556
As decision makers, you navigate complex financial landscapes where every line item impacts strategic decisions. While bad debt may seem like a routine accounting matter, it’s a powerful lever that, when managed effectively, can enhance financial clarity, optimize tax efficiency, and strengthen investor confidence. Knowing how to handle bad debt is crucial and the answer lies in seeing bad debt also as a tool, not a mere accounting footnote.
Choosing the right accounting method
There are two basic approaches on how to account for bad debt: Direct write-off and allowance method. Nevertheless, the choice is pivotal:
Direct Write-Off: Simple, but delays risk recognition and lacks GAAP compliance. Suitable only for very early-stage businesses with minimal credit exposure.
Allowance Method: Estimates future losses, providing a forward-looking view crucial for forecasting and robust financial reporting. It's essential for scaling businesses with recurring credit sales.
Implement the allowance method and update it quarterly, leveraging tools like HighRadius or BlackLine for automation and risk scoring. This ensures accurate, timely financial insights.
Understanding where bad debt comes from
Bad debt doesn’t just appear on your books but builds over time through specific patterns: late-paying customers, weak follow-up processes, or poorly structured sales terms. It also reveals business side of the story: how your business qualifies clients, sets incentives, and enforces discipline. In most cases, bad debt can be traced to one of four scenarios:
1. Fraud
This occurs when the customer never intended to pay. Common examples include fake identities, shell entities, or fraudulent transactions. These are hard to recover and typically indicate weak onboarding or insufficient credit checks.
2. Insufficient processes
Sometimes, the issue lies internally. Invoices are not chased, reminders are missed, or there is no clear ownership of collections. These failures turn manageable delays into permanent losses.
3. External shocks
Customers may default due to reasons outside their control - economic downturns, bankruptcies, currency risk, or geopolitical instability. These cases can’t be prevented but should be anticipated and factored into risk planning.
4. Disputes or dissatisfaction
Not all non-payment is financial. In some cases, customers withhold payment due to insufficient value delivery such asservice issues, product defects, or contract disputes. If these cases aren’t addressed early, they often end up as write-offs.
Identifying which of these scenarios is driving bad debt helps companies take more targeted action; whether that means improving credit vetting, tightening internal workflows, or closing feedback loops between departments.
Mitigating Bad Debt at the Source
Once the cause of bad debt is understood, it becomes easier to manage. The goal isn’t just to reduce write-offs—it’s to build systems that prevent them from happening. Each type of bad debt requires a different response.
Fraud mitigation
Fraudulent debt can’t be recovered, so the focus should be on prevention. Most fraud happens during onboarding or the first transaction, before credit risk even reaches finance.
Use fraud detection tools that flag high-risk behavior in real time. Platforms like SEON, Stripe Radar, or Riskified help identify red flags such as mismatched billing information, unverifiable domains, and rapid purchase activity. Combine these with basic checks like company registry validation, VAT number lookups, and conservative credit limits for first-time clients.
Process mitigation
Bad debt caused by internal process failures—missed reminders, unclear ownership, or lack of escalation—is common in growth-stage companies.
Establish structured dunning processes: automated, time-based reminders that escalate in tone and urgency. Assign clear responsibility for collections within the finance team and track key indicators such as Days Sales Outstanding (DSO), recovery rates, and aging trends. Ensure that collections are embedded in weekly operational routines, not treated as a reactive task.
External risk mitigation
Economic events or sector-specific disruptions can cause even strong customers to default. These shocks are outside your control, but exposure to them can be managed.
Track receivables concentration by geography, industry, and customer size. Apply credit limits in higher-risk segments and consider credit insurance where exposure is significant. For companies reporting under IFRS, maintain a provision buffer for receivables linked to sectors or regions under pressure.
Dispute mitigation
Payment delays driven by dissatisfaction often go unnoticed until they become write-offs. These cases are typically caused by gaps in service delivery, product quality, or expectation management.
Make disputed invoices visible in your ERP or CRM. Connect finance with customer success and account management to surface issues early. Track recurring problems like late deliveries or contract misunderstandings and feed them back into process improvements. Ensure that disputes are not only resolved but systematically reduced over time.
Tax Deductibility: What qualifies and why it matters
Once bad debt is identified - whether through aging analysis, dispute resolution, or fraud detection - the next step is understanding its financial implications. Beyond risk mitigation, bad debt write-offs play a direct role in shaping your tax position and year-end financial reporting. But for it to be deductible, it must meet certain conditions:
The revenue was previously recognized
The debt is wholly or partially worthless
Collection efforts are documented
The write-off is recorded in the correct fiscal year
Partial write-offs are allowed if properly supported. This matters especially for high-value receivables where partial recovery may still be possible.
Strategic Insight: Review aged receivables before year-end. Well-timed write-offs reduce tax exposure and improve your balance sheet ahead of audits or fundraising.
Strategic use of write-offs
Write-offs are often seen as reactive. But when used intentionally, they become a financial planning tool.
In high-income years, they can reduce tax liabilities. In investor or audit cycles, they help present a cleaner balance sheet. Bad debt is part of doing business when you sell on credit. But when unmanaged, it clouds your forecasts, weakens your margins, and sends the wrong signal to stakeholders.
Handled strategically, it becomes a source of control. It enables better reporting, sharper tax positioning, stronger investor confidence, and clearer operational decisions.
For growing companies, managing bad debt well is more than hygiene—it’s a hallmark of financial maturity.
Citations:
https://www.semanticscholar.org/paper/5d2c52ce5d8a23f57d598b184c3a708b34e91594
https://www.semanticscholar.org/paper/091d04812a5f25b872232e1c8c731a77f7d43bc5
https://www.semanticscholar.org/paper/1a872e062b0f0ee38fc73ac695e2e582a3878da0
https://www.semanticscholar.org/paper/552dd675f8f26d45ef07db5f3085da324d2eac9b
https://finance.cornell.edu/accounting/topics/revenueclass/baddebt
https://pro.bloombergtax.com/insights/federal-tax/deducting-business-bad-debt/
https://www.myob.com/au/resources/guides/accounting/bad-debt
https://blog.taxact.com/tax-deductions-non-business-bad-debts/
Turns out even biblical kings knew to write off bad debt before year-end (Matthew 18:21–35)
The Parable of the Unmerciful Servant, Jan Senders van Hemessen, 1556
As decision makers, you navigate complex financial landscapes where every line item impacts strategic decisions. While bad debt may seem like a routine accounting matter, it’s a powerful lever that, when managed effectively, can enhance financial clarity, optimize tax efficiency, and strengthen investor confidence. Knowing how to handle bad debt is crucial and the answer lies in seeing bad debt also as a tool, not a mere accounting footnote.
Choosing the right accounting method
There are two basic approaches on how to account for bad debt: Direct write-off and allowance method. Nevertheless, the choice is pivotal:
Direct Write-Off: Simple, but delays risk recognition and lacks GAAP compliance. Suitable only for very early-stage businesses with minimal credit exposure.
Allowance Method: Estimates future losses, providing a forward-looking view crucial for forecasting and robust financial reporting. It's essential for scaling businesses with recurring credit sales.
Implement the allowance method and update it quarterly, leveraging tools like HighRadius or BlackLine for automation and risk scoring. This ensures accurate, timely financial insights.
Understanding where bad debt comes from
Bad debt doesn’t just appear on your books but builds over time through specific patterns: late-paying customers, weak follow-up processes, or poorly structured sales terms. It also reveals business side of the story: how your business qualifies clients, sets incentives, and enforces discipline. In most cases, bad debt can be traced to one of four scenarios:
1. Fraud
This occurs when the customer never intended to pay. Common examples include fake identities, shell entities, or fraudulent transactions. These are hard to recover and typically indicate weak onboarding or insufficient credit checks.
2. Insufficient processes
Sometimes, the issue lies internally. Invoices are not chased, reminders are missed, or there is no clear ownership of collections. These failures turn manageable delays into permanent losses.
3. External shocks
Customers may default due to reasons outside their control - economic downturns, bankruptcies, currency risk, or geopolitical instability. These cases can’t be prevented but should be anticipated and factored into risk planning.
4. Disputes or dissatisfaction
Not all non-payment is financial. In some cases, customers withhold payment due to insufficient value delivery such asservice issues, product defects, or contract disputes. If these cases aren’t addressed early, they often end up as write-offs.
Identifying which of these scenarios is driving bad debt helps companies take more targeted action; whether that means improving credit vetting, tightening internal workflows, or closing feedback loops between departments.
Mitigating Bad Debt at the Source
Once the cause of bad debt is understood, it becomes easier to manage. The goal isn’t just to reduce write-offs—it’s to build systems that prevent them from happening. Each type of bad debt requires a different response.
Fraud mitigation
Fraudulent debt can’t be recovered, so the focus should be on prevention. Most fraud happens during onboarding or the first transaction, before credit risk even reaches finance.
Use fraud detection tools that flag high-risk behavior in real time. Platforms like SEON, Stripe Radar, or Riskified help identify red flags such as mismatched billing information, unverifiable domains, and rapid purchase activity. Combine these with basic checks like company registry validation, VAT number lookups, and conservative credit limits for first-time clients.
Process mitigation
Bad debt caused by internal process failures—missed reminders, unclear ownership, or lack of escalation—is common in growth-stage companies.
Establish structured dunning processes: automated, time-based reminders that escalate in tone and urgency. Assign clear responsibility for collections within the finance team and track key indicators such as Days Sales Outstanding (DSO), recovery rates, and aging trends. Ensure that collections are embedded in weekly operational routines, not treated as a reactive task.
External risk mitigation
Economic events or sector-specific disruptions can cause even strong customers to default. These shocks are outside your control, but exposure to them can be managed.
Track receivables concentration by geography, industry, and customer size. Apply credit limits in higher-risk segments and consider credit insurance where exposure is significant. For companies reporting under IFRS, maintain a provision buffer for receivables linked to sectors or regions under pressure.
Dispute mitigation
Payment delays driven by dissatisfaction often go unnoticed until they become write-offs. These cases are typically caused by gaps in service delivery, product quality, or expectation management.
Make disputed invoices visible in your ERP or CRM. Connect finance with customer success and account management to surface issues early. Track recurring problems like late deliveries or contract misunderstandings and feed them back into process improvements. Ensure that disputes are not only resolved but systematically reduced over time.
Tax Deductibility: What qualifies and why it matters
Once bad debt is identified - whether through aging analysis, dispute resolution, or fraud detection - the next step is understanding its financial implications. Beyond risk mitigation, bad debt write-offs play a direct role in shaping your tax position and year-end financial reporting. But for it to be deductible, it must meet certain conditions:
The revenue was previously recognized
The debt is wholly or partially worthless
Collection efforts are documented
The write-off is recorded in the correct fiscal year
Partial write-offs are allowed if properly supported. This matters especially for high-value receivables where partial recovery may still be possible.
Strategic Insight: Review aged receivables before year-end. Well-timed write-offs reduce tax exposure and improve your balance sheet ahead of audits or fundraising.
Strategic use of write-offs
Write-offs are often seen as reactive. But when used intentionally, they become a financial planning tool.
In high-income years, they can reduce tax liabilities. In investor or audit cycles, they help present a cleaner balance sheet. Bad debt is part of doing business when you sell on credit. But when unmanaged, it clouds your forecasts, weakens your margins, and sends the wrong signal to stakeholders.
Handled strategically, it becomes a source of control. It enables better reporting, sharper tax positioning, stronger investor confidence, and clearer operational decisions.
For growing companies, managing bad debt well is more than hygiene—it’s a hallmark of financial maturity.
Citations:
https://www.semanticscholar.org/paper/5d2c52ce5d8a23f57d598b184c3a708b34e91594
https://www.semanticscholar.org/paper/091d04812a5f25b872232e1c8c731a77f7d43bc5
https://www.semanticscholar.org/paper/1a872e062b0f0ee38fc73ac695e2e582a3878da0
https://www.semanticscholar.org/paper/552dd675f8f26d45ef07db5f3085da324d2eac9b
https://finance.cornell.edu/accounting/topics/revenueclass/baddebt
https://pro.bloombergtax.com/insights/federal-tax/deducting-business-bad-debt/
https://www.myob.com/au/resources/guides/accounting/bad-debt
https://blog.taxact.com/tax-deductions-non-business-bad-debts/
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