An Introduction
‘Bad Debt’ is a term which you might have encountered in Accountancy. But, most importantly, do you know what is debt? Debt is the amount of borrowed money being owed. The lender (here the company) agrees to lend the money or goods on credit to its debtors (here the outsiders of the company) for an agreed interest which will be charged with the principal debt amount, now if the debtor or the outsider do not repay the company back this debt becomes ‘bad’ thus turning the debt into a bad debt!
Pretty simply isn’t it? Let us know more on bad debt but before that, we will revise the meaning of Debt.
Meaning of Debt
Debt is the amount of money that is borrowed by one party from another party. Debt is used by many corporations and individuals as a method of making purchases in a good quantifiable amount which they could not afford under any normal circumstances. A Debt is an arrangement that gives the borrowing party permission to borrow money under the condition that the amount is to be paid back at a later date, also paid with an interest amount.
What do you mean by Bad Debt?
Bad Debt is a claim made by an organization that the amount cannot be collected from the customer because the customer is unable to pay the amount borrowed by the organization.
It is only agreed on terms that the borrowing party pays the amount borrowed with interest on time as discussed by both parties.
The Debtor's inability to repay the Debt may be due to bankruptcy of an individual or organization, serious financial problems, or the Debtor's unwillingness to repay the Debt.
The Allowance for doubtful accounts is recorded in the annual financial statements as an Allowance for doubtful accounts.
Bad Debts Meaning and Examples
Bad Debt is that Debt that was previously receivable but now is irrecoverable from that person who was supposed to pay that Debt. This means the Debt becomes Bad as it is unpaid. The reason for this non-payment may be the cause as the Debtors either get bankrupted or have financial problems, say the problem in the collection by the creditors for various reasons which are not possible. There are various definitions for Bad Debts to occur which will depend on the type of accounting.
Types of Bad Debts
There are types of Bad Debt that can be classified, although there are no set defined types of Bad Debt yet any business can incur the same.
We may classify the Bad dents according to different types of business models in the following category -
Traders – A business entity that sells and purchases the goods on credit, might incur Bad Debts in case his or her customer didn’t oblige to the predefined sets of terms and conditions of the payment for the purchase of these goods.
Service Providers – Similarly for a trader, a service provider may also incur Bad Debt loss in case his or her client does not repay the fees after utilizing the services provided by the service providers.
Repayment of Loan – For a person who is engaged in providing the loans, if a receiver does not repay his or her dues, then this will also amount to Bad Debts.
Court Order – In case of a dispute where out of any judicial authority, an order is pronounced directing any party to pay another party but still if the party fails to repay, this will also lead to creating Bad Debts.
An entity that buys and sells goods with credit allows customers to accept predefined payment terms for purchasing goods.
Like a retailer, a service provider may incur Bad Debt if the customer does not repay the fees for using the service provider's services.
If the recipient does not repay the Debt, it also means Bad Debt to the person who provides the loan.
If an out-of-court / court or judicial order is issued and a dispute is underway instructing one party to pay the other, but the party does not repay, then it is Bad Debt.
What causes Bad Debt?
There are many reasons why you may end up with Bad Debt. In some cases, you may simply have credited the wrong customer. If so, you should tighten your lending policy so that it does not happen in the future. It is also possible that your company is the result of a fraud that was deliberately targeted by a criminal. However, in most cases the reason is simple. Due to bankruptcy or bankruptcy, the customer simply cannot pay the invoice.
Bad Debt Example
Suppose XYZ manufactures books and sells them to retailers. Merchants will be given 30 days to pay the company XYZ after receiving the books. XYZ posts the accounts receivable on the balance sheet and records revenue.
However, after the 30-day deadline, XYZ recognizes that the retailer will not pay. After repeated attempts, they are still not able to collect the payment and will be considered Bad Debt.
Provision for Bad and Doubtful Debts
The Provision for the doubtful Debts, which is also referred to as the Provision for Bad Debts or even known as the Provision for losses on the accounts of receivable, is further estimation of the amount of the doubtful Debt which will need to be written off during a particular. This is a Provision or an Allowance for the Debts which are assumed to be doubtful.
The process of strategically estimating the Bad Debt accounts that need to be written off in the future is known as the Bad Debt Provision. There are several ways to make estimates, called Provisions, some of which are required by law and some of which are strategically prioritized. One way is to understand the past performance of loans in a particular population. In this way, you can make assessments based on previous trends and use specific data to support decision making.
Allowance for Bad Debts
An Allowance for Bad Debt is the valuation account that is used to estimate the amount of a firm's receivable which may later be ultimately uncollectible. This is also known as the Allowance for doubtful accounts. When a borrower defaults on any loan, then the Allowance for the Bad Debt account and the loan which is received is the balance that is both reduced for the book value of the loan amount.
Bad Debt Expense
A Bad Debt expense is recognized, at the time when a receivable is no longer collected as the customer is not able to fulfil their obligation to pay the outstanding Debt for the bankruptcy or other financial problems. The Companies which extend credit to their customers report these Bad Debts as an Allowance for the doubtful accounts on the balance sheet, which also provides for credit losses.
Bad Debt Reserve
A Bad Debt Reserve is the valued number of receivables that a company or financial institution does not intend to collect. This includes the business payments that become due and the loan repayments as well.
Ways to Write off a Bad Debt
There are two main ways that you can write off Bad Debt. These methods are as follows:
Bad Debt Direct write-off method
Bad Debt Provision method
Bad Debts Written Off Meaning
The Debt which cannot be recovered, and also which cannot be collected from a Debtor is the Bad Debt. The process is called writing off Bad Debt. Under the direct write-off method, the Bad Debts are shown as expensed. The company credits the accounts which are receivable on the balance sheet while debiting the Bad Debt expense account on the income statement.
FAQs on Bad Debt: Meaning and Practical Examples
1. What exactly is a 'bad debt' in simple terms, with an example?
A bad debt is an amount of money that a company must give up on collecting because the customer who owes it is unable or unwilling to pay. It is essentially a loss for the business. For example, if a shop sells goods worth ₹5,000 to a customer on credit and the customer later declares bankruptcy, that ₹5,000 becomes a bad debt for the shop.
2. What is the main difference between a 'good debt' and a 'bad debt'?
The key difference lies in their purpose and outcome. A good debt is typically money borrowed to acquire an asset that can generate income or increase in value, like a student loan for education or a loan to expand a business. A bad debt, from a creditor's perspective, is not a loan but an expense that arises when a customer fails to pay what they owe for goods or services already delivered.
3. How does a business record a bad debt in its accounts?
When a debt is confirmed as uncollectible, it is recorded as an expense. The standard journal entry is to debit the Bad Debts Expense account (which increases expenses) and credit the Accounts Receivable account (which decreases the amount owed by the specific customer).
4. What does 'Provision for Doubtful Debts' mean?
A Provision for Doubtful Debts is an estimate of the total bad debts that are likely to occur in an accounting period from the current set of debtors. Instead of waiting for each debt to become bad, businesses proactively set aside an amount from their profits to cover these anticipated losses. It is also known as an 'allowance for doubtful accounts'.
5. Why do companies create a provision for debts instead of just writing them off when they go bad?
Companies create a provision to follow the matching principle of accounting. This principle states that expenses should be recognised in the same period as the revenues they helped generate. By creating a provision, the potential loss (the bad debt expense) is matched with the sale that created it, giving a more accurate picture of the company's profitability for that period.
6. How do bad debts affect a company’s financial statements?
Bad debts impact both the Profit and Loss Statement and the Balance Sheet.
- On the Profit and Loss Statement, bad debt is shown as an operating expense, which reduces the company's net profit.
- On the Balance Sheet, the Provision for Doubtful Debts is subtracted from the total Accounts Receivable, presenting a more realistic and collectible value of debtors.
7. What happens if a customer pays a debt that was already written off as bad?
This is called a bad debt recovery, and it is treated as a gain for the business. The amount received is recorded as income in the period it is recovered. The accounting entry typically involves debiting the Cash account and crediting a 'Bad Debts Recovered' account, which is shown as an income in the Profit and Loss Statement.
8. What are the common methods used to account for bad debts?
There are two primary methods for accounting for bad debts:
- Direct Write-Off Method: The debt is written off directly as an expense only when it is confirmed to be uncollectible. This method is simpler but violates the matching principle.
- Allowance (Provision) Method: The company estimates future bad debts at the end of each period and creates a provision for them. This is the preferred method as it adheres to the matching principle.
9. How does a business decide when an amount owed is truly uncollectible?
A business decides a debt is uncollectible based on several factors, not just a feeling. Common indicators include:
- The customer has gone out of business or declared bankruptcy.
- All attempts to contact the customer have failed over a long period.
- The debt has passed a certain age (e.g., over 180 days past due).
- Legal action to recover the amount has been unsuccessful.
