Bad Debt

Bad debt is an amount due from a customer that they refuse to pay. When a company gives its customers credit, bad debts are always a possibility. They arise when a company extends too much credit to a customer and is unable to recollect it, which results in a payment that is either missing, reduced, or delayed. A bad debt may also be created by a customer who makes false representations about themselves to obtain credit and has no intention of making a repayment to the provider. The first scenario is caused by poor internal procedures or changes in a customer's ability to pay, whereas the second is caused by a client purposefully misleading.

Bad debt can occur for a variety of causes. In other circumstances, one might have simply credited the incorrect consumer. If so, the company should modify its lending criteria to prevent it from happening again. It is also possible that the bank got duped by fraud or scams that went unnoticed until it is too late. However, the cause is usually straightforward. The customer is unable to pay due to bankruptcy or insolvency.

Here is an example of bad debts to consider:

Let's imagine that a company produces gadgets and sells them in the market. After receiving the gadgets, a store has 30 days to reimburse the company. On the balance sheet, the company notes the revenue and the amount owed as "accounts receivable."

But as the 30-day deadline approaches, the company realizes the retailer won't pay. After numerous tries, the business was unsuccessful in collecting the amount; as a result, it will be regarded as a bad debt.

There are two ways to determine bad debt costs:

Direct Write-Off Method
Allowance Method

Direct Write-Off
In this approach, the bad debt is directly written off to the receivable account. It debits the bad debts account and credits the accounts receivable account.

One drawback of this system is that it does not follow the matching principle that is employed in accrual accounting, even though it records the precise amount of debt that has become uncollectible. The rule states that expenses should be documented at the moment of the transaction rather than when the payment is made.

Therefore, calculating bad debts theoretically is not particularly accurate.

Allowance Method
When a significant sum of money is at stake, this method is preferred. With this approach, the organization prepares for the possibility of bad debts by anticipating their occurrence.

For this, a counter asset account called an allowance for doubtful accounts is formed, which lowers the loan receivable account if both accounts are shown on the balance sheet.

When a sale is made, a projected sum is recorded as a bad debt and is credited to the allowance for doubtful accounts and debited to the bad debt expense account. When businesses seek to write off bad debt, they debit the allowance for dubious accounts and credit the accounts receivable account.