Bad Debt: What It Is And How You Can Write It Off

Bad debt doesn't refer to the moral failings of the borrower or lender. Instead, it has to do with the loan status and what creditors or individual lenders need to do. Though it’s far from ideal, bad debt happens — for lenders, the key to dealing with it is to understand how and when to write it off.

What Is Bad Debt?

Bad debt becomes a reality when a company approves a loan to a customer who can’t, in the end, pay back the full amount. Once a debt is considered uncollectible, it can be written off by the lender for tax purposes. It can also refer to individuals that have loaned out money and can prove that the borrower didn’t pay it back as intended.

For businesses, bad debt is a risk that needs to be taken into consideration because there’s always a chance that someone won’t pay back what they owe. As such, many companies consider bad debt an expense that can be estimated or calculated to ensure they remain profitable.

How Bad Debt Can Happen

Bad debt typically transpires when the borrower can’t pay back the loan, or when the lender has sufficient proof that the borrower won’t ever pay back what is owed, even partially.

Some reasons that lenders believe that a loan will not be repaid:

• A borrower has declared bankruptcy
• A borrower shows evidence of experience extreme financial difficulties
• A borrower refuses to repay the debt over a disagreement
• A borrower neglects to pay back their debt over a period of time

Because businesses want to avoid bad debt, they go through underwriting processes to assess whether borrowers have shown evidence of responsible payment behavior. That’s typically why those with higher credit scores tend to get offered the best rates and terms: their track record of on-time payments proves they’re able to handle debt responsibly. For individuals, protecting themselves from bad debt could entail making sure the borrower is a trustworthy individual or can show how they intend to make payments.

How To Record And Write Off Bad Debt

For businesses, bad debt may be written off so that the bookkeeping accurately reflects a business’ current accounts. Writing or charging off the bad debt will remove it from your accounts receivable and alter your balance sheets. That’s because it’s recorded as an expense. There are two methods to account for bad debt: the direct write-off method and the allowance method.

Direct Write-Off Method

The direct write-off method entails identifying debt that is considered uncollectible and writing it off. The exact or precise amount needs to be accounted for in order for the bad debt to be recorded.

Allowance Or Matching Method

The allowance method uses a matching principle where expenses need to be matched to income or revenue from the same time period when both happened. The bad debt expenses need to be estimated and will appear under the sales and general administrative expense area on a business' income statement. The amount is an estimated figure because it's hard to predict which debts will end up going into default.

Estimating A Bad Debt Expense

A bad debt expense (BDE) represents the loss you or your company experience from bad debt on receivables deemed uncollectible. Bad debt is typically recorded by accountants as a sales expense on a company’s income statement. There are different formulas on how businesses can estimate their loss from a bad debt expense.

Percentage Of Sales

This method involves taking a percentage of your net sales that's based on your experience with bad debt. It will apply a flat percentage to the total amount of sales for a certain period of time. For instance, if your business historically has 2% of bad debt from total loans and your business’ net sales is $300,000 this quarter, then you can estimate $6,000 will not be repaid.

Percentage Of Receivables

This method involves estimating a certain percentage that's based on available historical data on the total accounts receivable (AR) amount in order to predict how much bad debt there will be. So if your business were to estimate 3% in bad debt and it has a total of $600,000 in accounts receivable, then the estimated amount of bad debt would be $18,000.

Accounts Receivable Aging

This method looks at accounts receivables (AR), but groups it according to the age of outstanding account balances. Once these are grouped together, specific estimated percentages of bad debt are applied then aggregated to arrive at the total estimated uncollectible amount.

For instance, if $400,000 worth of AR has a 2% chance of it having bad debt, and $600,000 of it has a 1.5% chance, here’s how you would calculate it:

($400,000 x 2%) + ($600,000 x 1.5%) = $17,000

That means your business can estimate having $17,000 in bad debt.

The Bottom Line

Bad debt is money that ultimately won't be collected. While unfortunate, it is a risk businesses and lenders take. Because of this risk, businesses account for it by using a variety of methods to estimate bad debt and account for it in their bookkeeping.

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