What Is Bad Debt?
The term bad debt refers to an amount of money that a creditor must write off as a result of a default on the part of the debtor. 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 refers to loans or outstanding balances owed that are no longer deemed recoverable and must be written off.
- Incurring bad debt is part of the cost of doing business with customers, as there is always some default risk that is associated with extending credit.
- To comply with the matching principle, bad debt expense must be estimated using the allowance method in the same period in which the sale occurs.
- There are two main ways to estimate an allowance for bad debts: the percentage sales method and the accounts receivable aging method.
- Bad debts can be written off on both business and individual tax returns.
Understanding Bad Debt
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 that's a bank or other financial institution, a supplier, or a vendor.
Bad debts end up as such because the debtor can't 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 first is the direct write-off method, which involves writing off accounts when they are identified as uncollectible. While this method records the precise figure for accounts determined to be uncollectible, it fails to adhere to the matching principle used in accrual accounting and generally accepted accounting principles (GAAP).
The second is the matching principle, which requires that expenses be matched to related revenues in the same accounting period they are generated. Bad debt expense must be estimated using the allowance method in the same period and appears on the income statement under the sales and general administrative expense section. Since a company can't predict which accounts will end up in default, it establishes an amount based on an anticipated figure. In this case, historical experience helps estimate the percentage of money expected to become bad debt.
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 non-business 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.
How to Record Bad Debts
Recording bad debt involves a debit and a credit entry. Here's how it's done:
- A debit entry is made to a bad debt expense
- An offsetting credit entry is made to a contra asset account, which also referred to as the allowance for doubtful accounts
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.
Methods of Estimating Bad Debt
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 or an AR aging method, or through a percentage of net sales. We've highlighted the basics of each below.
Accounts Receivable Aging Method
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 increasing 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 x 1%) + ($30,000 x 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.
Percentage of Sales Method
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.