Bad debts

3 Key Takeaways

• Bad debts are irrecoverable amounts owed to a creditor.
• They are recognized as an expense in the income statement.
• Businesses can estimate bad debts using different methods like the percentage of sales or accounts receivable aging.

What are Bad Debts?

Bad debts, also known as uncollectible accounts or doubtful accounts, are debts that are unlikely to be paid by the borrower. This can occur for various reasons, such as bankruptcy, financial hardship, or deliberate non-payment. When a debt is deemed uncollectible, the creditor must write it off, removing it from their accounts receivable balance and recognizing it as an expense.

Importance of Bad Debts

• Financial Reporting: Accounting for bad debts ensures that a company’s financial statements accurately reflect its financial position.
• Tax Deduction: In many jurisdictions, bad debts can be deducted from taxable income, reducing the company’s tax liability.
• Risk Management: Understanding bad debts helps companies assess and manage credit risk, allowing them to make informed decisions about lending and credit policies.
• Cash Flow: Recognizing bad debts promptly can prevent companies from overstating their assets and cash flow, leading to more accurate financial forecasting and decision-making.

Real-World Applications

Bad debts are a natural part of doing business on credit. They are a cost of doing business and need to be accounted for by all entities that extend credit to their customers.

In financial accounting, bad debts are recognized as an expense in the income statement. They are typically estimated using either the percentage of sales method or the accounts receivable aging method. The percentage of sales method estimates bad debts as a percentage of total credit sales, while the accounts receivable aging method classifies receivables based on their age and assigns different percentages of uncollectibility to each category.

Once a debt is deemed uncollectible, it is written off by debiting the bad debt expense account and crediting the accounts receivable account. In some cases, if a previously written-off debt is recovered, it is reinstated by reversing the write-off entry.