From Wikipedia, the free encyclopedia Bad debt
Bad debt
A bad debt is an amount that is written off by the busi- Gross accounts receivable $100,000
ness as a loss to the business and classified as an expense
Less: Allowance for bad debts $5,000
because the debt owed to the business is unable to be col-
lected, and all reasonable efforts have been exhausted to Net receivables $95,000
collect the amount owed. This usually occurs when the In financial accounting and finance, bad debt is the por-
debtor has declared bankruptcy or the cost of pursuing tion of receivables that can no longer be collected, typ-
further action in an attempt to collect the debt exceeds ically from accounts receivable or loans. Bad debt in ac-
the debt itself. [1] [2] [3] counting is considered an expense.
The debt is immediately written off by crediting the There are two methods to account for bad debt:
debtor’s account and therefore eliminating any balance 1. - a receivable which is not considered collectible is
remaining in that account. A bad debt represents money charged directly to the income statement.
lost by a business which is why it is regarded as an ex- 2. - an estimate is made at the end of each fiscal year of
pense. the amount of bad debt. This is then accumulated in
a provision which is then used to reduce specific
receivable accounts as and when necessary.
Doubtful debt Because of the matching principle of accounting, rev-
Doubtful debts are those debts which a business or indi- enues and expenses should be recorded in the period in
vidual is unlikely to be able to collect. The reasons for which they are incurred. When a sale is made on account,
potential non payment can include disputes over supply, revenue is recorded along with account receivable. Be-
delivery, and conditions of goods or the appearance of fi- cause there is an inherent risk that clients might default
nancial stress within a customer’s operations. When such on payment, accounts receivable have to be recorded at
a dispute occurs it is prudent to add this debt or portion net realizable value. The portion of the account receiv-
thereof to the doubtful debt reserve. This is done to avoid able that is estimated to be not collectible is set aside in
over-stating the assets of the business as trade debtors is a contra-asset account called Allowance for doubtful Ac-
reported net of Doubtful debt. When there is no longer counts.
counts At the end of each accounting cycle, adjusting en-
any doubt that a debt is uncollectable the debt becomes tries are made to charge uncollectible receivable as ex-
bad. An example of a debt becoming uncollectable would pense. The actual amount of uncollectible receivable is
be:- once final payments have been made from the liqui- written off as an expense from Allowance for doubtful ac-
dation of a customer’s limited liability company, no fur- counts.
counts
ther action can be taken.
Taxability
Doubtful debt reserve Some types of bad debts expense, whether business or
nonbusiness related, are considered deductible. Section
Also known as bad debt reserve, this is a contra account 166 of the Internal Revenue Code provides the qualifica-
listed within current asset section of the balance sheet. tions which must be met in order to meet deductibility
Doubtful debt reserve will hold a sum of money to allow status.[4]
a reduction in the accounts receivable ledger due to non-
collection of debts. This can also be referred to as the al- Criteria for deduction
lowance for bad debts. Once a doubtful debt becomes un-
collectable, the amount will be written off. To be considered as deductible, debts:
• must be a bona fide debt, and
• worthless within the taxable year.
US accounting practice A debt is defined as a debt which arises from a debtor-
Allowance for bad debts are amounts expected to be un- creditor relationship based upon a valid and enforceable
collected, but still with possibilities of being collected obligation to pay a determinable sum of money. The debt
(when there is no other possibility for them to be col- in question must also be considered worthless. This dis-
lected, they are considered as uncollectible accounts
accounts). tinction is further broken down into the level of col-
For example, if gross receivables are $100,000 and the lectibles. One must determine whether the qualifying
amount that is expected to remain uncollected is $5,000, debt is completely or partially worthless. A partially
net current asset section of balance sheet will be: worthless status means a portion of the debt may be re-
1
From Wikipedia, the free encyclopedia Bad debt
covered in future periods. Numerous factors are taken in- debt must be completely worthless in order to be deduct-
to consideration including the debtor’s insolvency status, ed. However, a business bad debt is deductible whether it
health conditions, credit standing, etc.[5] is partially or completely worthless.
Section 166 References
Section 166 does limit the amount of deduction allowed. [1] http://www.apm.com.au/osbuyers/glossary.htm
There must be an amount of tax capital, or basis, in ques- [2] http://www.allbusiness.co
tion to be recovered. In other words, is there an adjusted [3] http://financial-dictionary.thefreedictionary.com/
basis for determining a gain or loss for the debt in ques- Bad+Debt
tion. [4] TaxAlmanac - Internal Revenue Code:Sec. 166. Bad
An additional factor in applying the criteria is the debts
classification of the debt (nonbusiness or business). A [5] Tax Topics - Topic 453 Bad Debt Deduction
business bad debt is defined as a debt created or acquired
in connection with a trade or business of the taxpayer.
Whereas, a nonbusiness debt is defined as a debt that is
External links
not created or acquired in connection with a trade or • Bad Debts
business of the taxpayer. The classification is quite sig- • NYSSCPA’s glossary of accounting terms
nificant in terms of the deductibility. A nonbusiness bad
Retrieved from "http://en.wikipedia.org/w/index.php?title=Bad_debt&oldid=462417176"
Categories:
• Expense
• Debt
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