Bad debt definition
/What is a Bad Debt?
A bad debt is a receivable that a customer will not pay. Bad debts are possible whenever credit is extended to customers. They arise when a company extends too much credit to a customer that is incapable of paying back the debt, resulting in either a delayed, reduced, or missing payment. A bad debt may also occur when a customer misrepresents itself in obtaining a sale on credit, and has no intent of ever paying the seller. The first situation is caused by bad internal processes or changes in the ability of a customer to pay. The second situation is caused by a customer intentionally engaging in fraud.
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Credit and Collection Guidebook
Accounting for Bad Debt
There are two ways to record a bad debt, which are the direct write-off method and the allowance method. The direct write-off method is more commonly used by smaller businesses and those using the cash basis of accounting. An organization using the accrual basis of accounting will probably use the allowance method. Both options are discussed below.
Direct Write-Off Method
If you only reduce accounts receivable when there is a specific, recognizable bad debt, then debit the bad debt expense for the amount of the write off, and credit the accounts receivable asset account for the same amount. The direct write-off method is not the best approach, because the charge to expense may occur several months after you recorded the related revenue, so there is no matching of revenue and expense within the same period (the matching principle).
Allowance Method
If you charge an estimated amount of accounts receivable to bad debt expense in the same period when you record related revenue, then debit the bad debt expense for the amount of the estimated write-off, and credit the allowance for doubtful accounts contra account for the same amount. The amount of the allowance is usually based on the firm’s historical experience with similar receivables. Older receivables may be assigned a higher probability of loss, while newer ones are assigned a lower probability. For example, receivables less than 30 days old may be assigned a loss probability of 2%, while those at least 90 days old are assigned a loss probability of 40%. If the receivables in the first group total $100,000 and those in the second group total $20,000, then the loss allowance would be $6,000 (calculated as (1% x $100,000) + (40% x $20,000)).
The allowance method has the advantage of matching expected bad debts to revenues in the period when the revenues are recognized, even if you don't know exactly which accounts receivable will not be collectible. The allowance will likely need to be adjusted from time to time, since the estimated amount of bad debt will not exactly match the amount that is actually written off.
Accounting for a Received Payment on a Bad Debt Write-Off
It is not entirely true that a bad debt will never be collected. It is possible that a customer will pay extremely late, in which case the original write-off of the related receivable should be reversed, and the payment charged against it. Do not create new revenue to reflect the receipt of a late cash payment on a written-off receivable, since doing so would overstate revenue.
It is more likely that a very late payment will be in a reduced amount, because the customer negotiated for a lower payment. If so, the unpaid portion of the debt should still be classified as a bad debt.
How to Reduce Bad Debt
There are several ways to reduce your total amount of bad debt, as noted below:
Reduce credit. You can reduce the amount of credit granted to your more problematic customers. This will necessarily reduce the amount of sales you will generate from them, and may turn them away entirely. However, if your bad debt level is destroying profits, then this may be a reasonable option.
Obtain credit insurance. Offload your bad debt exposure to a credit insurance company. These parties evaluate your customers and charge you an insurance premium to take on your bad debt exposure. However, if they think a customer is too high a credit risk, they will refuse to grant any insurance coverage on sales to that customer.
Aggressive collections. You can bulk up your collections staff, and begin pursuing overdue payments as soon as possible. Doing so should decrease your total bad debt write-off, but at the incremental cost of the additional collections staff.