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What is bad debt?
When you first hear about the term bad debt, you may think, “but wait, isn’t all debt ‘bad’?” Absolutely not – debt is a fundamental part of business, and just as you can have bad debt, you can have good debt too. If you’ve got receivables that will be repaid at an agreed-upon time, possibly with interest, you’re dealing with good debt. However, if it’s no longer possible to collect on your receivables, you’re going to need to know how to deal with the bad debt on your books. We’ve got you covered.
Bad debt meaning
Simply put, a bad debt is a type of expense that occurs after repayment by a customer (when credit has been extended) is no longer considered to be collectable. In other words, bad debt is an irrecoverable receivable. Any businesses that extend credit to their customers must account for the possibility of bad debt, as there’s always a chance that your customer’s circumstances will change and they won’t be able to complete payment as agreed.
Why do bad debts happen?
There are a broad range of reasons why you may end up dealing with a bad debt. In some cases, you may have simply extended credit to an unsuitable customer. If this is the case, you should look to tighten up your credit policy to stop it from happening in the future. It could also be the result of fraud wherein your business has been deliberately targeted by criminals. In most cases, however, the reason is simple: the customer simply cannot pay your bill due to insolvency or bankruptcy.
How to record a bad debt
There are two main ways that you can record a bad debt in accounting. These methods are as follows:
Bad debt write-off
Bad debt provision
It’s important to note that the bad debt write off method doesn’t adhere to the matching principle associated with generally accepted accounting principles (GAAP). Therefore, if you’re using GAAP for accounting, you’ll need to use the bad debt provision method instead. Some countries such as those in the UK use international financial reporting standards (IFRS) instead of GAAP, but it’s important to remember that the way you record bad debt expenses may differ depending on the country you’re based in.
Here’s a little more information about these accounting methods of recording bad debt expenses:
Bad debt write-off method explained
Bad debt write-offs are used when you have a specific and recognisable bad debt on your accounts, i.e. you know that the debt is irrecoverable. In the bad debt write-off method, you’ll debit the bad debt expense for the amount of the write off and credit the accounts receivable asset account for the same amount.
Bad debt provision method explained
A bad debt provision or allowance, also known as a provision for doubtful debts, is an accounting method that requires you to estimate the amount of bad debt that you’ll need to write off in any given period. In essence, you’ll charge an estimated amount of accounts receivable to bad debt expense, before debiting the bad debt expense for the estimated amount of the write-off. Finally, you’ll credit the same amount to the bad debt provision contra account.
Why is it important to understand bad debts?
Thriving businesses can run into difficulty at the drop of a hat, and reliable customers who always pay their debts can become problematic non-payers within a relatively short space of time. As a result, it’s always important to be prepared to deal with bad debt expenses. Furthermore, businesses are judged by potential investors on their financial statements, which means that a bad debt could make your business look like it isn’t doing as well as it is in reality. Consequently, it’s important to classify bad debts as bad debts so that investors can see that all your accounts are in good order.
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