A trade receivable is money a customer owes your business for goods or services you have already delivered but have not yet been paid for. It sits on the balance sheet as a current asset because you expect to collect the cash within a year.1Legal Information Institute. Current Asset Every credit sale creates one, and every trade receivable stays on your books until the customer pays or you write the balance off as uncollectible.
Trade Receivables Versus Everything Else Owed to You
Trade receivables come from your core business: selling products or providing services on credit. When you ship an order or finish a project and send an invoice, the unpaid balance is a trade receivable.
Not every dollar owed to your company qualifies. Non-trade receivables cover everything else, including interest owed on investments, insurance claims you have filed, tax refunds you are expecting, and advances made to employees. The line matters because trade receivables show how well your actual revenue converts into cash, while non-trade receivables reflect incidental amounts that say little about how the business operates.
Notes receivable are a third, separate category. When a customer cannot pay on standard terms, you might agree to a formal promissory note with a repayment schedule and interest. That formalizes the obligation and moves it out of ordinary trade receivables into its own line item, even though it started as a credit sale.2Lumen Learning. Trade and Non-Trade Receivables
How the Entry Hits Your Books
When you issue an invoice, you record the full amount as a debit to accounts receivable and a credit to revenue. At that moment, the balance sheet shows the gross receivable and the income statement reflects the sale. Under accrual accounting, the revenue counts the day you earn it by delivering the goods or services, not the day the cash arrives.
Reporting the gross number alone would overstate what you will actually collect. Accounting standards require you to show trade receivables at their net realizable value: the gross invoiced amount minus your best estimate of what customers will not pay. That estimate lives in a contra-asset account called the Allowance for Doubtful Accounts, which carries a credit balance offsetting the receivables’ normal debit balance. Anyone reading the balance sheet sees the net figure, which is what you realistically expect to turn into cash.
The matching expense is bad debt expense on the income statement. Recording it in the same period as the sale it relates to keeps the financials honest. Book $500,000 in credit sales this quarter, expect a 2% loss rate based on history, and $10,000 in bad debt expense goes on the books now. That prevents you from overstating this quarter’s profit and absorbing the losses as a surprise later.
When a specific customer’s account is finally confirmed uncollectible, you write it off by debiting the Allowance for Doubtful Accounts and crediting accounts receivable. The net receivable balance does not change, because the expected loss was already recognized when you set the allowance.
Estimating What You Will Not Collect
Two approaches govern the estimate, and which one you use depends on what the numbers are for.
The Allowance Method
The allowance method is the accepted approach for financial reporting. You estimate uncollectible amounts before specific customers default, then adjust the Allowance for Doubtful Accounts. Two techniques drive the estimate.
The first is a percentage of credit sales. You apply a flat rate based on historical experience to total credit sales for the period. If your three-year average write-off rate is 1.5% of credit sales, that percentage sets the current period’s bad debt expense.
The second is an aging analysis. You sort outstanding receivables into time buckets, typically current, 1–30 days past due, 31–60 days, 61–90 days, and over 90 days. Each bucket gets a progressively higher estimated default rate, because the longer an invoice goes unpaid, the less likely you are to collect it. The total across all buckets becomes your required allowance balance. Aging tends to produce more accurate estimates than the flat percentage because it reflects the actual composition of your receivables at a point in time.
The Direct Write-Off Method
The direct write-off method skips estimation. You record bad debt expense only when a specific customer’s account is confirmed uncollectible. Because the expense often lands in a different period than the revenue it relates to, this violates the matching principle and is not acceptable under GAAP for financial reporting. It is, however, the required method for federal income tax purposes.3Lumen Learning. Direct Write-Off and Allowance Methods That means many businesses run both calculations: the allowance method for their financial statements, the direct write-off method for the tax return.
CECL for GAAP Filers
Companies that follow U.S. GAAP apply the Current Expected Credit Losses framework under Topic 326. Where the older incurred-loss model waited for evidence that a loss had probably already happened, CECL requires you to estimate lifetime expected losses from the moment you record the receivable. That front-loads loss recognition and makes balance sheets more conservative.
Applying CECL to short-lived trade receivables created real cost and complexity, particularly for smaller companies asked to build forward-looking economic forecasts for invoices that might be collected in 30 days. The FASB responded in 2025 with ASU 2025-05, which introduced a practical expedient letting all entities assume that current conditions as of the balance sheet date remain unchanged for the remaining life of the receivable.4Financial Accounting Standards Board. FASB Issues Standard that Improves Measurement of Credit Losses for Accounts Receivable and Contract Assets Private companies received an additional option to consider post-balance-sheet-date collection activity when setting loss estimates.
Metrics That Tell You If Collections Are Working
Accounts Receivable Turnover
The turnover ratio measures how many times during a period your company collects its average receivables balance. Divide net credit sales by average accounts receivable. A company with $2 million in net credit sales and an average receivables balance of $250,000 has a turnover ratio of 8, meaning it cycles through its receivables eight times a year.
A high ratio signals that customers pay quickly and your credit policies are working. A low ratio points to slow-paying customers, generous credit terms, or a collection process that needs attention. The number is most useful compared against your own prior periods or against competitors in the same industry, because a healthy ratio varies widely by sector.
Days Sales Outstanding
DSO translates turnover into something more intuitive: the average number of days between making a sale and collecting the cash. Divide the days in the period (typically 365) by the turnover ratio. A turnover ratio of 8 works out to a DSO of about 46 days.
The real value of DSO is comparison against your stated credit terms. A DSO of 46 when your terms are Net 45 is healthy. A DSO of 55 when your terms are Net 30 means customers are routinely paying late, and the gap is tying up working capital. Watching DSO trend over several quarters often surfaces problems earlier than raw receivable balances do.
When a Receivable Goes Bad: The Tax Side
When a trade receivable becomes uncollectible, you may be able to deduct the loss on your federal tax return. Under 26 U.S.C. § 166, a business can deduct a debt that becomes wholly or partially worthless during the tax year.5Office of the Law Revision Counsel. 26 USC 166 – Bad Debts To qualify, you need to show that you took reasonable steps to collect and that the facts indicate no reasonable expectation of repayment. You do not have to sue the customer, but you do need to demonstrate that a court judgment would be uncollectible.6Internal Revenue Service. Topic no. 453, Bad Debt Deduction
One catch trips up a lot of small businesses: you can only deduct a bad debt if the amount was previously included in your gross income.6Internal Revenue Service. Topic no. 453, Bad Debt Deduction Accrual-basis businesses recognize revenue when the sale occurs, so the receivable is already in gross income and a deduction is available. Cash-basis businesses do not report income until cash is received. Since the income from an unpaid invoice was never reported, there is nothing to deduct.
The deduction has to be taken in the year the debt becomes worthless. You cannot stockpile old bad debts and claim them all in a convenient future year. If you miss the year, the IRS allows you to file an amended return, but the window is limited.
The Setup That Prevents Trouble Later
The best time to reduce collection problems is before you extend credit. A written credit policy should spell out maximum credit limits for each customer, standard payment terms, and what happens when invoices go unpaid. Most businesses use terms such as Net 30, meaning full payment is due within 30 days, or offer early-payment incentives like 1/10 Net 30, which gives the customer a 1% discount for paying within 10 days. Set the terms deliberately, record the receivable properly, estimate the losses honestly, and the balance sheet number will mean what it says.