Bad Debt

Business, Legal & Accounting Glossary

Definition: Bad Debt


Quick Summary of Bad Debt


Bad debt is the portion of a company’s receivables that are uncollectible. Companies account for bad debt either by the direct method or the allowance method. Under the direct method, the company reduces accounts receivable when a specific invoice is deemed uncollectible. While this method may seem logical, it is only allowed when total bad debt is small and immaterial. Under the allowance method, the company estimates the portion of accounts receivable that will be uncollectible and periodically records charges for bad debt expense. The allowance method is preferred because (a) it recognizes that bad debt is a normal, continually recurring cost of doing business, and (b) under the matching principle, the cost of bad debt more closely corresponds to reported revenue in the accounting period. A significant rise in the bad debt to accounts receivable and bad debt to sales ratios indicate greater risk and a deterioration in the quality of the company’s revenues. On the other hand, no or minuscule bad debt may indicate that the firm is too conservative in extending credit.



What is the dictionary definition of Bad Debt?

Dictionary Definition


noun
  1. a debt that cannot be recovered.

Bad debt is a loss that a company incurs when credit that has been extended to customers becomes worthless, either because the debtor is bankrupt, has financial problems or because it can’t be collected.

n. an uncollectible debt. The problem is to determine when a debt is realistically dead, which means there must be some evidence of uncollectibility or a lengthy passage of time. Discharge in bankruptcy, the running of the statute of limitations to bring a lawsuit, disappearance of the debtor, a pattern of avoiding debts or the destruction of the collateral security can all make a debt “bad.” For income tax deduction purposes such a debt in business is deductible against ordinary income (found in federal income tax Form 1040 Schedule C) and such a personal debt is deductible against short-term capital gains. A debt due for services rendered is not a bad debt for tax purposes, since there is just no income on which to be taxed.


Full Definition of Bad Debt


In 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.

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 statement.

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.

US Accounting Practice

Because of the matching principle of accounting, revenues and expenses 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 collectable 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 as expense the uncollectible receivable. The actual amount of uncollectible receivable is written off as an expense from Allowance for Doubtful Accounts to the account called Bad Debt Expense.

Taxability

Some types of bad debts, whether business or nonbusiness related, are considered deductible. Section 166 of the Internal Revenue Code provides the qualifications which must be met in order to meet deductibility status.

Criteria for deduction:

  • 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 collectables. 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 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 it 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.


Examples of Bad Debt in a sentence


Bad debt has significantly and negatively impacted the bank’s profits this year.
The Auditors concluded that the volume of bad debt was wholly unacceptable and could be financially disastrous.
There is good debt and then there is bad debt.
The agency is excellent at recovering bad debt.
The company has had to allow for a £3 million provision for bad debt.
If they had acted more cautiously in the first instance; the banks would have had less bad debt to declare.
It only has a few subsidiaries to shunt bad debt into.
Profits in 1994 were bolstered by a significant fall in bad debt provisions to £372 million.


Synonyms For Bad Debt


bad loans, doubtful accounts, doubtful debts, bad debts, uncollectible receivables

Cite Term


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Bad Debt. PayrollHeaven.com. Payroll & Accounting Heaven Ltd. July 05, 2020 https://payrollheaven.com/define/bad-debt/.
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Bad Debt. PayrollHeaven.com. Payroll & Accounting Heaven Ltd. https://payrollheaven.com/define/bad-debt/ (accessed: July 05, 2020).
American Psychological Association (APA):
Bad Debt. PayrollHeaven.com. Retrieved July 05, 2020, from PayrollHeaven.com website: https://payrollheaven.com/define/bad-debt/

Definition Sources


Definitions for Bad Debt are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 26th April, 2020 | 26 Views.