Bad Debt Expense: How to Calculate, Track, and Manage It Efficiently

Lenders often face the challenge of borrowers failing to repay credit after it’s extended. Unpaid debts can disrupt cash flow, increase financial risk, and impact profitability negatively. Without a structured approach to track and manage bad debt, these losses can pile up, making it difficult to maintain a healthy lending business.

Bad debt expense represents the portion of receivables that a lender or company expects will not be collected. Tracking and minimizing this expense is essential for maintaining financial stability. In this guide, I’ll explain what bad debt expense is, why it matters, how to calculate it, and the best ways to track and manage it efficiently.

If you’re a lender looking to improve loan servicing and financial health, this guide is for you.

Bad debt expense is the estimated cost of loans or credit that a lender expects to remain unpaid due to borrower-related issues such as default, financial hardship, bankruptcy, or even fraud. Whenever credit is extended, there’s always a risk that some borrowers might default, resulting in financial losses. This expense shows up in financial statements to account for loans and credit that are unlikely to be recovered.

How Bad Debt Affects Financial Health

When borrowers fail to repay, lenders experience:

• Cash Flow Disruptions – Unpaid debts reduce available cash for new lending opportunities.
  
  
• Lower Profitability – Write-offs directly impact a lender’s bottom line.
  
  
• Increased Risk Exposure – Uncontrolled bad debt can make future lending riskier.

For example, if a lender issues $100,000 in loans but anticipates that $5,000 will not be collected, then that $5,000 is recorded as bad debt expense.

Impact on Financial Statements

Bad debt expense reduces net income and affects the accuracy of financial reports. Overstating revenue without factoring in bad debt can give a false impression of a company’s financial health. If expected losses from uncollected payments are not accounted for, the reported revenue may appear higher than what the business will actually make. This can mislead stakeholders, such as investors and creditors, into believing the company is more profitable and financially stable than it truly is.

Regulatory Compliance

Accurate reporting of bad debt expenses is essential for tax filings and regulatory compliance. Internal Revenue Code (IRC) Section 166 allows businesses to deduct bad debts that become wholly or partially worthless, provided they follow the appropriate accounting method. Additionally, Financial Accounting Standards Board (FASB) ASC 326 (CECL Model) requires lenders to estimate expected credit losses over the life of a loan, ensuring timely and accurate recognition of bad debt expenses.

Non-compliance with these regulations can lead to financial misstatements, tax penalties, and scrutiny from regulatory bodies, making it crucial for lenders to align their bad debt estimation methods with these standards.

Risk Management

Tracking bad debt allows lenders to refine lending strategies. By analyzing past-due accounts, lenders can identify patterns in borrower behavior, refine credit policies, and set stricter lending criteria for high-risk borrowers. 

These insights can also be used to improve collection strategies, such as implementing proactive reminders, negotiating payment plans, or enforcing late fees, ultimately reducing defaults and improving cash flow.

There are two main methods for calculating bad debt expense: the Direct Write-Off Method and the Allowance Method.

1. Direct Write-Off Method

This method records bad debt only when a specific account is determined to be uncollectible.

Here’s how to calculate and record it:

Step 1: Identify the Uncollectible Account

Determine which borrower’s loan is uncollectible. In this case, a borrower has defaulted on a $3,000 loan.

Step 2: Record the Bad Debt Expense

Once the account is deemed uncollectible, record the bad debt as an expense in the accounting period it occurs.

Debit: Bad Debt Expense $3,000 (to recognize the loss)

Credit: Accounts Receivable $3,000 (to remove the uncollectible amount from the books)

• Impact on Financial Statements

The company’s expenses increase, reducing net income.

The accounts receivable balance decreases, reflecting the removal of the unpaid loan.

This method is simple but lacks accuracy because it does not estimate future bad debts, potentially overstating revenue before the default occurs.

2. Allowance Method

This method estimates bad debt in advance, ensuring that uncollectible accounts are accounted for before they occur.

Here’s how to calculate and record it:

Step 1: Estimate Bad Debt Expense

Before any accounts become uncollectible, the company estimates bad debt based on historical data. Suppose the company has $20,000 in accounts receivable and expects 5% to be uncollectible:

E.g, 20,000 × 5% =1,000

Step 2: Record the Estimated Bad Debt Expense

Instead of waiting for an account to default, the company records the estimated bad debt as an expense and creates an allowance to offset future losses.

Debit: Bad Debt Expense $1,000 (to recognize the anticipated loss)

Credit: Allowance for Doubtful Accounts $1,000 (to reserve funds for future bad debts)

Step 3: Write Off an Uncollectible Account

Later, a borrower defaults on a $500 loan. Since the loss was already anticipated, the company wrote it off without impacting the income statement again.

Debit: Allowance for Doubtful Accounts $500 (to reduce the reserve)

Credit: Accounts Receivable $500 (to remove the uncollectible amount)

• Impact on Financial Statements

The initial estimate (Step 2) ensures expenses are recognized in the correct period, preventing overstated revenue.

The write-off (Step 3) does not impact net income since it was accounted for earlier.

Accounts receivable remain more accurate, reflecting only collectible amounts.

This method provides a more accurate financial picture, ensuring bad debt expenses are recognized before defaults occur.

Tracking bad debt efficiently requires the right tools and processes. Here are some of the most recommended ways:

1. Automating Loan Servicing & Receivables Monitoring

Loan servicing software, like Bryt Software, helps track overdue accounts automatically. Its automated Payment Tracking feature helps lenders track overdue accounts in real-time. This automation improves accuracy, ensures timely follow-ups on delinquent accounts, and helps reduce the risk of missed payments.

2. Using Aging Reports & Analytics

Aging reports break down overdue accounts by how long they’ve been past due—30, 60, 90 days—so you can spot high-risk loans and focus on collections before they turn into bad debt. With Bryt’s Custom Reports, you can create Accounts Receivable Aging Reports that fit your needs, whether that’s filtering by loan type, risk level, or outstanding balance. This way, you get a clear picture of where to take action and keep your portfolio in check.

Here’s how an expert puts it into practice:

3. Analyzing Historical Trends & Predicting Future Defaults

By analyzing past default patterns, lenders can pinpoint risk factors, understand borrower behavior, and fine-tune lending policies to reduce future defaults. For example, patterns in late payments might reveal that borrowers with variable income sources are at higher risk, prompting lenders to adjust terms or offer flexible repayment options. 

The analytics dashboard takes this further by identifying early warning signs (like multiple late payments in a short period), so lenders can intervene before a loan turns into bad debt. This not only improves financial planning but also strengthens risk management by allowing lenders to act before defaults happen.

1. Proactive Credit Risk Assessment

A strong credit risk strategy starts before the loan is even issued. Evaluating borrower creditworthiness with strict approval criteria helps minimize bad debt risk. But it doesn’t stop there—ongoing monitoring through credit checks and financial reviews ensures lenders can catch warning signs early. For high-risk borrowers, safeguards like collateral or co-signers add an extra layer of protection.

Here’s how an industry leader puts it into practice:

2. Effective Collections Strategies

Preventing late payments isn’t just about setting clear terms—it’s about understanding why borrowers struggle and addressing those root causes before they escalate. Many lenders focus on enforcement, but a more effective approach is integrating behavioral insights into repayment strategies. Additionally, offering structured incentives—such as interest reductions for consistent payments—can encourage better financial habits.

Let’s take a look at what an expert has to say on this:

In some cases, a simple adjustment to payment terms is enough, but for borrowers facing more significant financial strain, modifying or refinancing their loan may be a better solution. Understanding when to adjust terms, modify a loan, or refinance can make a big difference in managing risk while keeping borrowers on track. Loan Modification vs. Loan Refinancing: Choosing the Best Option for Your Borrowers breaks down the key differences and how lenders can make informed decisions.

Additionally, a step-by-step escalation process keeps overdue accounts in check. Start with friendly reminders to prompt payments without straining borrower relationships. If delays continue, move to formal notices and credit term adjustments. For persistent non-payment, stricter actions (such as credit holds or legal measures) may be necessary. Regularly reviewing borrower payment patterns ensures that policies stay effective and responsive to changing risks.

3. Utilizing Technology for Risk Mitigation

Real-time financial monitoring and customizable credit terms help lenders identify early signs of financial distress and adjust conditions for high-risk borrowers.

By using alternative data, such as spending habits and cash flow analysis, lenders can make more informed decisions, reducing risk and improving loan performance.

4. Legal Considerations

Lenders must have clear policies on when to escalate non-payment cases to collection agencies or pursue legal action. Factors such as the duration of delinquency (e.g., 90+ days overdue), borrower payment history, outstanding balance, and likelihood of recovery should guide this decision. Conducting a cost-benefit analysis is important to determine whether legal action is worth pursuing. 

Proper documentation is critical for successful collections or legal proceedings. Lenders should maintain signed loan agreements, payment history, communication logs, and notices of missed payments to support their case if legal action becomes necessary. Bryt’s Document Management Module securely stores and organizes this documentation, ensuring lenders have easy access to essential records when needed.

1. Ignoring Early Warning Signs

Many lenders fail to track early signs of delinquency, such as missed due dates, partial payments, or a sudden change in borrower behavior. Instead of waiting until an account becomes severely overdue, lenders should implement real-time monitoring tools to detect risk factors early.

2. Relying on Outdated Calculation Methods

Relying on manual processes or outdated spreadsheets can lead to inaccurate bad debt estimates, causing financial misstatements and poor decision-making. Implementing an automated bad debt calculation system improves accuracy by incorporating historical default trends, borrower risk analysis, and real-time payment data. 

3. Neglecting Customer Communication

Lack of borrower engagement increases the likelihood of missed payments and default. A strong communication strategy, including automated payment reminders, personalized repayment plans, and financial counseling options, can significantly reduce bad debt. Borrower engagement tools facilitate direct communication, ensuring lenders can provide guidance and maintain strong borrower relationships.

Understanding and managing bad debt is important for maintaining profitability and good financial health. By accurately calculating bad debt, closely monitoring overdue accounts, and implementing proactive risk management strategies, lenders can minimize financial losses.

Technology plays a crucial role in the process of minimizing bad debt risk. Loan tracking tools and borrower engagement solutions help lenders detect early signs of delinquency and take action before issues escalate. A modern loan servicing solution can make it much easier to streamline collections and improve financial health. With features like real-time monitoring and data-driven insights, Bryt is one such software that can help lenders stay ahead of potential defaults and improve loan performance.