What Is Bad Debt?
Let me start by defining bad debt for you—it's essentially money owed to a creditor that goes unpaid because the borrower defaults on the loan. If you're a business extending credit, this becomes an uncollectible amount you have to charge off. You need to account for it as a contingency since there's always a risk customers won't pay up. We can estimate these uncollectibles using methods like accounts receivable aging or percentage of sales.
Understanding Bad Debt
Bad debt arises when any lender, be it a bank, supplier, or vendor, extends credit that the debtor can't or won't repay due to bankruptcy, financial issues, or negligence. You might pursue collection or legal action, but if that fails, it's deemed uncollectible. In accounting, you handle this with either the direct write-off method, which records it precisely when identified but doesn't follow the matching principle in GAAP, or the allowance method, which estimates it in the same period as the sale to match expenses with revenues. Historical data helps you predict the percentage that will turn bad.
Special Considerations
The IRS lets you write off bad debt on your tax return if you reported it as income before—think loans to clients, credit sales, or guarantees, but not things like unpaid rents or salaries. For instance, if you deliver goods on credit in December and the customer folds in January without paying, deduct it the next year. Individuals can also deduct nonbusiness bad debts as short-term capital losses if it was a genuine loan, not a gift. Remember, bad debt in a broader sense means borrowing for non-appreciating goods that doesn't boost your net worth, unlike good debt that generates income.
How to Record Bad Debts
Recording bad debt is straightforward: debit the bad debt expense and credit the allowance for doubtful accounts, a contra-asset that offsets your accounts receivable on the balance sheet. This way, you're only showing the collectible amount. The allowance builds over time and gets adjusted based on your estimates. If you later recover payments on written-off debts, book them as bad debt recovery.
Methods of Estimating Bad Debt
You estimate bad debt to report accurate financials, using either the AR aging method or percentage of sales. The AR aging method groups receivables by age and applies increasing percentages to older ones, reflecting higher default risk— for example, with $70,000 under 30 days at 1% and $30,000 over at 4%, you'd allow $1,900. Adjustments in later periods only add the difference. The percentage of sales method takes a flat rate of net sales based on history; if 3% of $100,000 sales is uncollectible, allow $3,000, and build on that in subsequent periods.
Frequently Asked Questions
You might wonder what bad debt means in accounting—it's the uncollectible amount from customers, recorded as an expense that reduces accounts receivable via direct write-off or allowance methods, with allowance preferred under GAAP. It's a normal business cost when offering credit, so estimate it yearly for budgeting. Technically, it's not an asset but an expense offsetting the receivable asset through the allowance account.
The Bottom Line
In the end, bad debt is unavoidable if you offer credit—it's uncollectible amounts you account for by debiting expenses and crediting contra-assets, reducing your receivables. Use these methods to estimate and manage it effectively in your operations.
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