What is Bad Debt?
Bad debts are the result of customers failing to repay the credit they received from businesses. These debts are considered uncollectable and irrecoverable, and they indicate that the customers are facing financial difficulties. Bad debts are different from good debts, which are the credit that customers pay back on time. Good debts can help businesses increase their sales and cash flow, while bad debts can reduce their profitability and liquidity. I.e., it is important for businesses to record and monitor their bad debts, as they reflect the uncertainty and risk of their credit policy.
Bad Debts Explained
Bad debts are the receivables that businesses cannot collect from their customers. These debts arise when customers default on their credit obligations, either due to financial hardship or intentional evasion. Bad debts can occur in various contexts, such as trading, lending, or other forms of credit extension.
In trading, businesses may offer deferred payment options to their customers for goods and services. While most customers honor their payment terms, some may intentionally avoid or delay paying their dues. In lending, borrowers may take loans from banks or other financial institutions and fail to repay their installments, resulting in legal actions against them.
How to write off Bad Debts?
Bad debt is the accounting term for the credit that businesses cannot recover from their customers. To record bad debt, businesses need to make two journal entries:
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A debit entry to increase the bad debt expenditure, which is an income statement account that reduces the net income
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A credit entry to increase the allowance for doubtful accounts, which is a contra-asset account that reduces the net receivables on the balance sheet
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The allowance for suspense accounts represents the estimated amount of uncollectible receivables. This allowance is adjusted periodically based on the balance in the account and the expected credit losses.
Sometimes, businesses may receive payments for bad debt that they have already written off. This is called bad debt recovery, and it requires reversing the previous write-off entries and recording the cash receipt