a business expense rendered uncollectible once a client fails to repay the credit the company or financial institution extended to them.
Bad Debt Details
Bad debt is an inevitable expense for a business as some transactions may require credit. When a financial institution or company extends credit to a customer, it puts itself at risk as payment. There is no gaurantee that a customer will pay it back. If they don't pay it back—not even after collections—it is bad debt.
A bad debt arises from:
- Extending excess credit to a customer with a history of delayed or reduced payments
- When a customer presents false information on their creditworthiness to obtain more credit with no plans of repaying
The first situation results from bad internal decision-making, whereas the second can be disregarded as fraud because it is intentional. If the bad debt materializes, the business can choose to proceed in one of two ways:
- Write off bad debts
- Allowance method
The write-off method is more straightforward, and a business recognizes that the debt is irrecoverable. It proceeds to debit the debt expense account and credit the corresponding asset account for the same.
Hypothetical Example of a Bad Debt
Let’s assume Sandra runs a business supplying tiles to company B. Company B has been a loyal customer for over five years and has established a good working relationship with Sandra. Sandra has no problem supplying tiles to company B on credit because they always make their payments on time.
A few months later, Sandra finds out from reliable sources that company B has been evading tax payments for years. As a result, it is no longer in operation. Company B misrepresented information as they had not been filing tax returns as required, and Sandra had no idea of the situation. This means that Sandra will be unable to collect any pending payments owed to her.
Sandra has to examine her business accounts and choose a suitable method to record the bad debt. She can either choose to write it off or use the allowance method to keep her accounts in order.
Significance of Recording Bad Debts
Every business keeps its accounts organized to ensure that they can accurately report their financial standing at the end of every fiscal year. This is especially important if they are seeking investors. Ideally, these statements exhibit a high level of integrity and reliability.
If a company fails to submit truthful statements, it can jeopardize its chances of acquiring investors. No investor would want to put their hard-earned money in a company with false financial statements. Recording bad debts is also a good method for a company to do internal clean-ups and make informed decisions.
A company can identify customers who have a habit of defaulting and choose to terminate any business contract they may have with them. Regular customer credit monitoring will keep the business on its toes and ensure that they maintain only creditworthy customers. The clean-up will also help the company identify clients who have shown loyalty to the business by paying on time.