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Somer G. Anderson is CPA, doctor of accounting, and an accounting and finance professor who has been working in the accounting and finance industries for more than 20 years. Her expertise covers a wide range of accounting, corporate finance, taxes, lending, and personal finance areas.
Fact checked by Fact checked by Ryan EichlerRyan Eichler holds a B.S.B.A with a concentration in Finance from Boston University. He has held positions in, and has deep experience with, expense auditing, personal finance, real estate, as well as fact checking & editing.
Bad debt is an amount of money that a creditor must write off if a borrower defaults on the loans. If a creditor has a bad debt on the books, it becomes uncollectible and is recorded as a charge-off.
Bad debt is a contingency that must be accounted for by all businesses that extend credit to customers, as there is always a risk that payment won’t be collected. These entities can estimate how much of their receivables may become uncollectible by using either the accounts receivable (AR) aging method or the percentage of sales method.
Bad debt is any credit advanced by any lender to a debtor that shows no promise of ever being collected, either partially or in full. Any lender can have bad debt on their books, whether it’s a bank or other financial institution, a supplier, or a vendor.
Bad debts end up as such because the debtor can’t pay or refuses to pay because of bankruptcy, financial difficulty, or negligence. These entities may exhaust every possible avenue to collect on bad debts before deeming them uncollectible, including collection activity and legal action.
Businesses must account for bad debt expenses using one of two methods.
The direct write-off method is used in the United States for income tax purposes.
The Internal Revenue Service (IRS) allows businesses to write off bad debt on Schedule C of tax Form 1040 if they previously reported it as income. Bad debt may include loans to clients and suppliers, credit sales to customers, and business loan guarantees. However, deductible bad debt does not typically include unpaid rents, salaries, or fees.
For example, a food distributor that delivers a shipment to a restaurant on credit in December will record the sale as income on its tax return for that year. But if the restaurant goes out of business in January and does not pay the invoice, the food distributor can write off the unpaid bill as a bad debt on its tax return in the following year.
Individuals are also able to deduct a bad debt from their taxable income if they previously included the amount in their income or loaned out cash and can prove that they intended to make a loan at the time of the transaction and not a gift. The IRS classifies nonbusiness bad debt as short-term capital losses.
The term “bad debt” can also be used to describe debts that are taken to pay for goods that don’t appreciate. In other words, bad debt is a form of borrowing that doesn’t help your bottom line. In this sense, bad debt is in contrast to good debt, which an individual or company takes out to help generate income or increase their overall net worth.
Recording bad debt involves a debit and a credit entry. Here’s how it’s done:
The allowance for doubtful accounts nets against the total AR presented on the balance sheet to reflect only the amount estimated to be collectible. This allowance accumulates across accounting periods and may be adjusted based on the balance in the account.
Payments received later for bad debts that have already been written off are booked as bad debt recovery.
We’ve established that bad debts must be recorded. But what amounts are listed on corporate financial statements? This involves estimating uncollectible balances using one of two methods. This can be done through statistical modeling using an AR aging method or through a percentage of net sales.
We’ve highlighted the basics of each below.
The AR aging method groups all outstanding accounts receivable by age, and specific percentages are applied to each group. The aggregate of all groups’ results is the estimated uncollectible amount. This method determines the expected losses to delinquent and bad debt by using a company’s historical data and data from the industry as a whole. The specific percentage typically increases as the age of the receivable increases to reflect rising default risk and decreasing collectibility.
Let’s say a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding. Based on previous experience, 1% of AR less than 30 days old will not be collectible, and 4% of AR at least 30 days old will be uncollectible.
This means the company must report an allowance and bad debt expense of $1,900. This is calculated as:
($70,000 × 1%) + ($30,000 × 4%)
If the next accounting period results in an estimated allowance of $2,500 based on outstanding accounts receivable, only $600 ($2,500 - $1,900) will be the bad debt expense in the second period.
A bad debt expense can be estimated by taking a percentage of net sales based on the company’s historical experience with bad debt. This method applies a flat percentage to the total dollar amount of sales for the period. Companies regularly make changes to the allowance for doubtful accounts so that they correspond with the current statistical modeling allowances.
Using the example above, let’s say a company expects that 3% of net sales are not collectible. If the total net sales for the period is $100,000, the company establishes an allowance for doubtful accounts for $3,000 while simultaneously reporting $3,000 in bad debt expense.
If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $2,400 is recorded in the second period in bad debt expense. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400.
Bad debt is debt that creditor companies and individuals can write off as uncollectible.
Bad debt is considered a normal part of operating a business that extends credit to customers or clients. Companies should estimate a total amount of bad debt at the beginning of every year to help them budget for that year and account for non-collectible receivables.
Bad debt is a contra asset, which reduces a business’s accounts receivable.
Bad debt is debt that cannot be collected. It is a part of operating a business if that company allows customers to use credit for purchases. Bad debt is accounted for by crediting a contra asset account and debiting a bad expense account, which reduces the accounts receivable.
Article SourcesDebtor-in-possession (DIP) financing is a special kind of financing meant for companies that are in bankruptcy.
Project finance is the financing of long-term infrastructure and industrial projects using a nonrecourse or limited-recourse financial structure.
A debt instrument is a tool an entity can use to raise capital. Any type of instrument primarily classified as debt can be considered a debt instrument.
Recovery rate is the extent to which principal and accrued interest on defaulted debt can be recovered, expressed as a percentage of face value.
A surety is the organization or person that assumes the responsibility of paying the debt in case the debtor policy defaults or is unable to make the payments.
A Uniform Commercial Code Financing Statement (Form UCC-1) is a document that serves as a lien on commercial property in a business loan.
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