What is Bad Debt? How to Record Bad Debts?

You can have both good debts and bad debts while running a business. If you extend credit to your customer and your get repaid within the time agreed upon it is considered good debt.   When the customers don’t pay you back, the loss is considered bad debt. You should have a clear understanding of what is bad debt and how to record them.

what is bad debt Bad debt

What is Bad Debt?

Bad debt refers to the credit you extended and outstanding balances owed to your company that can’t be recovered from your customers. These debts are deemed to be written off by your business. All businesses that extend credit to their customers have the risk of bad debt.  This is simply the receivable that can’t be recovered. This can be caused by customers who don’t pay you back due to insolvency, bankruptcy, or fraud. Offering credit to unfit customers is one of the major causes of bad debt. You should have a strict credit policy and always do enough research on the clients before extending credit.

How to Record Bad Debt?

Now that you know what is bad debt. You should understand how to record them. There are mainly two main ways to record bad debt;

  1. Write-off method
  2. Allowance method.

Write-off method

Writing off bad debt doesn’t adhere to the principles associated with generally accepted accounting policies (GAAP). So, if you follow GAAP accounting principles it is best recommended to follow the allowance method. Write off are generally made by small businesses that follow cash-based accounting.

When writing off your debt, you only reduce your receivables if there is a recognizable bad debt. The amount that needs to be written off should be debited as a bad debt expense and credited the same amount in the account receivable asset account.  In case the customer clears the debt extremely late, the original write-off related receivable and the payment charged should be reversed. Do not create a new expense to receipt to reflect the payments as it will overstate the revenue.

Allowance method

The allowance method is also known as a provision for doubtful debts. While using the allowance method, bad debt should be accounted for in the same period in which the sale has occurred. Most businesses that follow accrual-based accounting prefer the allowance method as it records bad debt expenses closer to the time of sale in the income statement.

The amount of credit that is not recovered is debited in allowance for doubtful accounts and credited to the accounts receivable account. The company will estimate the number of losses due to bad debt and record the adjusting entry at the end of every accounting period.

Why is it Important to Understand Bad Debt?

Bad debts should be recorded carefully. Lack of knowledge will make it difficult to record it accurately. It is something that you wouldn’t expect in the first place. Business owners should be prepared to deal with bad debts. Improper recording of bad debt might cause problems during tax time. If you’re looking for investors, bad debts can make it look like your business is underperforming. Having your accounts in order and recognizing bad debts accurately can solve this problem.
Writing off bad debts is much simpler but it is not recommended often and is mostly followed by cash-based businesses. Although the allowance method can be complicated, it allows businesses to represent bad debt much more accurately than write-offs.

If you need help knowing what is bad debt in detail and recording them, we can help you. Agile e-Platform provides end-to-end accounting solutions and ensures your business finances are accurate and tax-ready.

Get in touch with us to know more.

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