Bad debt

Bad debt refers to the amount that a business or individual cannot collect from debtors due to their default. Bad debt is often written off as an expense in the debtor's books and records after all reasonable collection efforts have been exhausted.

Definition

Bad debt is a term used in accounting to indicate funds that are not collectible. It is an expense that a business incurs once the repayment of credit previously extended to a customer is estimated to be uncollectible. Bad debt is a contingency that must be accounted for by all businesses who extend credit to customers, as there is always a risk that payment will not be received.

Causes

The primary cause of bad debt is the debtor going into bankruptcy. However, there are other reasons, such as the debtor disappearing, a dispute over the goods or services provided, or the debtor refusing to pay.

Accounting for Bad Debt

In accounting, bad debt can be treated in two ways: the direct write-off method and the allowance method. The direct write-off method involves charging the bad debt expense once it is certain that the debt is irrecoverable. The allowance method, on the other hand, involves estimating bad debts in advance and creating an allowance for doubtful accounts.

Impact on Financial Statements

Bad debt has a direct impact on the income statement, where it is recorded as an expense. It reduces the net income and, by extension, the owner's equity. On the balance sheet, bad debt reduces accounts receivable when it is written off.

Recovery of Bad Debt

In some cases, bad debt may be recovered if the debtor ends up making the payment or if the business takes legal action against the debtor. The recovery of bad debt is recorded as income in the financial statements.

See Also

• Debt
• Bankruptcy
• Accounts receivable
• Income statement
• Balance sheet