Overview

In finance, bad debt, occasionally called uncollectible accounts expense, is a monetary amount owed to a creditor that is unlikely to be paid and for which the creditor is not willing to take action to collect for various reasons, often due to the debtor not having the money to pay, for example due to a company going into liquidation or insolvency. A high bad debt rate is caused when a business is not effective in managing its credit and collections process.

If the credit check of a new customer is not thorough or the collections team is not proactively reaching out to recover payments, a company faces the risk of a high bad debt. Various technical definitions exist of what constitutes a bad debt, depending on accounting conventions, regulatory treatment and institution provisioning. In the United States, bank loans with more than ninety days' arrears become "problem loans". Accounting sources advise that the full amount of a bad debt be written off to the profit and loss account or a provision for bad debts as soon as it is foreseen.

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, the condition of the item, 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 debtors are reported net of doubtful debt. When there is no doubt that a debt is uncollectible, the debt becomes bad.

An example of a debt becoming uncollectible would be: once final payments have been made from the liquidation of a customer's limited liability company, no further action can be taken.

Doubtful debt reserve

Also known as a bad debt reserve, this is a contra account listed within the current asset section of the balance sheet. The doubtful debt reserve holds 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 an allowance for bad debts. Once a doubtful debt becomes uncollectible, the amount will be written off.

United States

In financial accounting and finance, bad debt is the portion of receivables that can no longer be collected, typically from accounts receivable or loans. Bad debt in accounting is considered an expense.

The matching principle of accounting calls for revenues and expenses to 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.

Taxability

Some types of bad debts, whether business or non-business-related, are considered tax deductible. Section 166 of the Internal Revenue Code provides the requirements for which a bad debt to be deducted.