Bad debt
Encyclopedia
A bad debt is an amount that is written off by the business as a loss to the business and classified as an expense because the debt owed to the business is unable to be collected, and all reasonable efforts have been exhausted to collect the amount owed. This usually occurs when the debtor
has declared bankruptcy or the cost of pursuing further action in an attempt to collect the debt exceeds the debt itself.
The debt is immediately written off by crediting the debtor
's account and therefore eliminating any balance remaining in that account. A bad debt represents money lost by a business which is why it is regarded as an expense.
s is reported net of Doubtful debt. When there is no longer any doubt that a debt
is uncollectable the debt becomes bad. An example of a debt becoming uncollectable would be:- once final payments have been made from the liquidation
of a customer's limited liability company
, no further action can be taken.
section of the balance sheet
. Doubtful debt reserve will hold a sum of money to allow a reduction in the accounts receivable
ledger due to non-collection of debts. This can also be referred to as the allowance for bad debts. Once a doubtful debt becomes uncollectable, the amount will be written off
.
section of balance sheet
will be:
In financial accounting and finance
, bad debt is the portion of receivables that can no longer be collected, typically from accounts receivable
or loan
s. Bad debt in accounting is considered an expense.
There are two methods to account for bad debt:
Because of the matching principle
of accounting, revenue
s and expense
s should be recorded in the period in which they are incurred. When a sale is made on account, revenue is recorded along with account receivable. Because there is an inherent risk that clients might default
on payment, accounts receivable have to be recorded at net realizable value
. The portion of the account receivable that is estimated to be not collectible is set aside in a contra-asset account called Allowance for doubtful Accounts. At the end of each accounting cycle, adjusting entries
are made to charge uncollectible receivable as expense. The actual amount of uncollectible receivable is written off as an expense from Allowance for doubtful accounts.
provides the qualifications which must be met in order to meet deductibility status.
A debt is defined as a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a determinable sum of money. The debt in question must also be considered worthless. This distinction is further broken down into the level of collectibles. One must determine whether the qualifying debt is completely or partially worthless. A partially worthless status means a portion of the debt may be recovered in future periods. Numerous factors are taken into consideration including the debtor’s insolvency status, health conditions, credit standing, etc.
An additional factor in applying the criteria is the classification of the debt (nonbusiness or business). A business bad debt is defined as a debt created or acquired in connection with a trade or business of the taxpayer. Whereas, a nonbusiness debt is defined as a debt that is not created or acquired in connection with a trade or business of the taxpayer. The classification is quite significant in terms of the deductibility. A nonbusiness bad debt must be completely worthless in order to be deducted. However, a business bad debt is deductible whether it is partially or completely worthless.
Debtor
A debtor is an entity that owes a debt to someone else. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor...
has declared bankruptcy or the cost of pursuing further action in an attempt to collect the debt exceeds the debt itself.
The debt is immediately written off by crediting the debtor
Debtor
A debtor is an entity that owes a debt to someone else. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor...
's account and therefore eliminating any balance remaining in that account. A bad debt represents money lost by a business which is why it is regarded as an expense.
Doubtful debt
Doubtful debts are those debts which a business or individual is unlikely to be able to collect. The reasons for potential non payment can include disputes over supply, delivery, and conditions of goods or the appearance of financial stress within a customer's operations. When such a dispute occurs it is prudent to add this debt or portion thereof to the doubtful debt reserve. This is done to avoid over-stating the assets of the business as trade debtorDebtor collection period
The term Debtor Collection Period indicates the average time taken to collect trade debts. In other words, a reducing period of time is an indicator of increasing efficiency. it enables the enterprise to compare the real collection period with the granted/theoretical credit period.Debtor Collection...
s is reported net of Doubtful debt. When there is no longer any doubt that a debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
is uncollectable the debt becomes bad. An example of a debt becoming uncollectable would be:- once final payments have been made from the liquidation
Liquidation
In law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation...
of a customer's limited liability company
Limited liability company
A limited liability company is a flexible form of enterprise that blends elements of partnership and corporate structures. It is a legal form of company that provides limited liability to its owners in the vast majority of United States jurisdictions...
, no further action can be taken.
Doubtful debt reserve
Also known as bad debt reserve, this is a contra account listed within current assetCurrent asset
In accounting, a current asset is an asset on the balance sheet which can either be converted to cash or used to pay current liabilities within 12 months...
section of the balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
. Doubtful debt reserve will hold a sum of money to allow a reduction in the accounts receivable
Accounts receivable
Accounts receivable also known as Debtors, is money owed to a business by its clients and shown on its Balance Sheet as an asset...
ledger due to non-collection of debts. This can also be referred to as the allowance for bad debts. Once a doubtful debt becomes uncollectable, the amount will be written off
Write-off
The term write-off describes a reduction in recognized value. In accounting terminology, it refers to recognition of the reduced or zero value of an asset. In income tax statements, it refers to a reduction of taxable income as recognition of certain expenses required to produce the income...
.
US accounting practice
Allowance for bad debts are amounts expected to be uncollected, but still with possibilities of being collected (when there is no other possibility for them to be collected, they are considered as uncollectible accounts). For example, if gross receivables are $100,000 and the amount that is expected to remain uncollected is $5,000, net current assetCurrent asset
In accounting, a current asset is an asset on the balance sheet which can either be converted to cash or used to pay current liabilities within 12 months...
section of balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
will be:
| Gross accounts receivable | $100,000 |
| Less: Allowance for bad debts | $5,000 |
| Net receivables | $95,000 |
In financial accounting and finance
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, bad debt is the portion of receivables that can no longer be collected, typically from accounts receivable
Accounts receivable
Accounts receivable also known as Debtors, is money owed to a business by its clients and shown on its Balance Sheet as an asset...
or loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
s. Bad debt in accounting is considered an expense.
There are two methods to account for bad debt:
- Direct write off method (Non-GAAP) - a receivable which is not considered collectible is charged directly to the income statementIncome statementIncome statement is a company's financial statement that indicates how the revenue Income statement (also referred to as profit and loss statement (P&L), statement of financial performance, earnings statement, operating statement or statement of operations) is a company's financial statement that...
. - Allowance method (GAAP) - an estimate is made at the end of each fiscal year of the amount of bad debt. This is then accumulated in a provision which is then used to reduce specific receivable accounts as and when necessary.
Because of the matching principle
Matching principle
The matching principle is a culmination of accrual accounting and the revenue recognition principle. They both determine the accounting period, in which revenues and expenses are recognized. According to the principle, expenses are recognized when obligations are incurred The matching principle...
of accounting, revenue
Revenue
In business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....
s and expense
Expense
In common usage, an expense or expenditure is an outflow of money to another person or group to pay for an item or service, or for a category of costs. For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture or an automobile is often...
s should be recorded in the period in which they are incurred. When a sale is made on account, revenue is recorded along with account receivable. Because there is an inherent risk that clients might default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
on payment, accounts receivable have to be recorded at net realizable value
Net realizable value
Net realizable value is a method of evaluating an asset's worth when held in inventory, in the field of accounting. NRV is part of the Generally Accepted Accounting Principles and International Financial Reporting Standards that apply to valuing inventory, so as to not overstate or understate the...
. The portion of the account receivable that is estimated to be not collectible is set aside in a contra-asset account called Allowance for doubtful Accounts. At the end of each accounting cycle, adjusting entries
Adjusting entries
In accounting/accountancy, adjusting entries are journal entries usually made at the end of an accounting period to allocate income and expenditure to the period in which they actually occurred. The revenue recognition principle is the basis of making adjusting entries that pertain to unearned and...
are made to charge uncollectible receivable as expense. The actual amount of uncollectible receivable is written off as an expense from Allowance for doubtful accounts.
Taxability
Some types of bad debts expense, whether business or nonbusiness related, are considered deductible. Section 166 of the Internal Revenue CodeInternal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
provides the qualifications which must be met in order to meet deductibility status.
Criteria for deduction
To be considered as deductible, debts:- must be a bona fide debt, and
- worthless within the taxable year.
A debt is defined as a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a determinable sum of money. The debt in question must also be considered worthless. This distinction is further broken down into the level of collectibles. One must determine whether the qualifying debt is completely or partially worthless. A partially worthless status means a portion of the debt may be recovered in future periods. Numerous factors are taken into consideration including the debtor’s insolvency status, health conditions, credit standing, etc.
Section 166
Section 166 does limit the amount of deduction allowed. There must be an amount of tax capital, or basis, in question to be recovered. In other words, is there an adjusted basis for determining a gain or loss for the debt in question.An additional factor in applying the criteria is the classification of the debt (nonbusiness or business). A business bad debt is defined as a debt created or acquired in connection with a trade or business of the taxpayer. Whereas, a nonbusiness debt is defined as a debt that is not created or acquired in connection with a trade or business of the taxpayer. The classification is quite significant in terms of the deductibility. A nonbusiness bad debt must be completely worthless in order to be deducted. However, a business bad debt is deductible whether it is partially or completely worthless.
External links
- Bad Debts
- NYSSCPA's glossary of accounting terms