How to Account for Bad Debt

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What is bad debt in accounting?

There are many different types of debt in the financial world, and bad debt is one of these. In accounting, bad debt refers to the amount of money owed to a company that is unlikely to be collected from its customers. In essence, you can expect to never receive the income acquired through this particular type of customer.

This type of debt is typically associated with accounts receivable, which represents the amounts owed to a company for goods sold or services rendered on credit. When a customer fails to make the required payment within the agreed-upon terms, the company may classify that debt as bad debt.

When do bad debts occur in finance?

As with all debt, bad debt can arise from various causes and scenarios, and it is important to understand these factors to effectively manage and address the debt situation, as not all customers within this category intend to end up in this situation.

Defaulting on consumer loans

Bad debts can occur with personal loans. If individuals default on their loan payments or become delinquent, their debt may be classified as a bad debt.

Failing to pay business loans

Companies can experience bad debts when they lend money to other businesses or individuals and those borrowers fail to repay the borrowed funds. This could happen due to financial difficulties that make it unlikely for the debt to be collected.

Unable to make credit payments

Bad debts can also occur when a company extends credit to its customers for the sale of goods or services and those customers fail to make the necessary payments. This typically happens when customers become insolvent, go out of business, or simply refuse to pay.

It’s important to note that bad debts are generally recognized when it becomes evident that the debt is uncollectible. The specific timing of when a debt is considered bad will depend on various factors.

Why do you record a bad debt?

It’s worth noting that the method used to record bad debts can vary. The two commonly used methods are the direct write-off method and the allowance method. The choice between these methods depends on the company’s size, industry, and accounting policies. You can read more about these further within this article.

Accounting standards require companies to record bad debt as an expense in their financial statements. This is done to reflect the realistic value of accounts receivable and to ensure that the company’s financial statements provide an accurate representation of its financial position. Bad debt is usually recorded as an expense in the income statement, often under an account called “Bad Debt Expense” or “Uncollectible Accounts Expense.” There are a few reasons as to why it needs to be recorded:

  1. Accurate financial reporting: Recording bad debts allows for accurate financial reporting. By recognizing the potential loss from uncollectible debts, the financial statements provide a more realistic view of a company’s financial position and performance.
  2. Matching principle: The recording of bad debts follows the matching principle, which aims to match expenses with the revenue they generate. Since you recognise revenue when you have made a sale of a product or service, the associated bad debt expense should also be recognized in the same period to reflect the true cost of earning that revenue.
  3. Conservatism: Recognizing bad debts demonstrates a conservative approach by acknowledging the possibility that not all accounts receivable will be collected.
  4. Reliable valuation of assets: By accounting for bad debts, the company ensures that the value of its accounts receivable is presented realistically. Failing to recognize bad debts would overstate the value of assets and misrepresent the financial position of the company, which can lead to a host of other issues.
  5. Decision-making: Accurate recording of bad debts provides management with important information for decision-making. It helps them to make informed decisions about extending credit in the future.

Why do you record a bad debt

How to write off bad debt?

Writing off a bad debt involves removing the uncollectible amount from the accounts receivable and recognizing it as an expense. The specific steps to write off bad debt can vary depending on the accounting method being used (direct write-off method or allowance method). Here are the general steps for both methods:

Direct write-off method

  1. Identify the specific account receivable that is deemed uncollectible. This is typically determined based on prior payments, communication with the customer, and collection efforts made.
  2. Prepare a journal entry to write off the bad debt. Debit the “Bad Debt Expense” account, which is an expense account on the income statement, and credit the specific customer’s accounts receivable account on the balance sheet.
  3. Update the general ledger and subsidiary ledger by posting the journal entry to the respective accounts.
  4. Depending on the accounting system being used, you may also need to update the customer’s balance in the accounts receivable aging report.

Allowance method

  1. Assess the overall estimate for bad debts by reviewing historical data, industry averages, and any specific information about customers’ financial situations.
  2. Calculate the required amount for the allowance for doubtful accounts. This is the estimated portion of accounts receivable that is expected to become uncollectible. It is typically a percentage based on past experience or a specific provision based on individual circumstances.
  3. Prepare a journal entry to increase the allowance for doubtful accounts. Debit the “Bad Debt Expense” account and credit the “Allowance for Doubtful Accounts” account. This increases the allowance to reflect the estimated uncollectible amount.
  4. Identify the specific account receivable that is deemed uncollectible and write it off. Prepare a journal entry to remove the uncollectible amount from the accounts receivable. Debit the “Allowance for Doubtful Accounts” account and credit the specific customer’s accounts receivable account.
  5. Update the general ledger and subsidiary ledger by posting the journal entries to the respective accounts.
  6. Make necessary adjustments to the accounts receivable aging report and other relevant reports to reflect the write-off and changes to the allowance.

It’s important to consult with an accounting professional or refer to your organization’s specific accounting policies and procedures to ensure proper compliance and accurate recording of bad debt write-offs.

Why is it important to understand bad debts?

Understanding bad debts is crucial for several reasons:

Financial planning and analysis

Understanding bad debts helps in accurate financial planning and analysis. By assessing the potential risk of uncollectible debts, businesses can make more realistic revenue projections, estimate cash flow, and set appropriate credit policies. It enables better decision-making regarding credit extension, debt collection strategies, and financial forecasting.

Accurate financial statements

Bad debts impact a company’s financial statements. Recognizing and properly recording bad debts ensures that the financial statements present a true and fair view of the company’s financial position and performance. This is important for those who rely on accurate financial information for evaluation and decision-making.

Risk management

Bad debts pose a significant risk to a company’s financial health. Understanding the level of bad debts helps identify potential credit risks and take proactive measures to mitigate them. You might implement a stricter credit approval processes or adjust your credit terms.

Cash flow management

Uncollected debts directly impact a company’s cash flow. By understanding bad debts, businesses can assess their impact on liquidity, make informed decisions about cash flow management, and take appropriate measures to ensure sufficient working capital.

Evaluation of customer creditworthiness

Understanding bad debts helps in evaluating the creditworthiness of customers. By analyzing historical bad debt data, payment patterns, and credit scores, businesses can assess the likelihood of timely payment and make informed decisions about extending credit. This reduces the risk of future bad debts and enhances overall risk management.

Compliance and auditing

Properly accounting for bad debts is essential for compliance with accounting standards and regulations. Understanding bad debt provisions, write-offs, and related accounting principles ensures compliance with applicable financial reporting frameworks.


Can financial modeling software help with managing bad debt?

Yes, a comprehensive financial modeling software can be helpful in managing bad debt by providing analytical capabilities and assisting in making informed decisions. Here are some ways in which the Brixx financial modeling tool can support the management of bad debt:

Scenario analysis

Financial modeling tools allow you to create and analyze various scenarios related to bad debt. You can input different assumptions and variables to understand the potential impact of bad debts on financial statements, cash flow, and key performance indicators. This helps in assessing the sensitivity of your financials to changes in bad debt levels and developing contingency plans accordingly.

Cash flow forecasting

Accurate cash flow forecasting is crucial for managing bad debts. Financial modeling tools enable you to create detailed cash flow models, incorporating factors such as customer payment terms, historical collection patterns, and anticipated bad debt levels. By modeling different scenarios and analyzing the projected cash flows, you can identify potential cash flow gaps and take proactive measures to mitigate the impact of bad debts on liquidity.

Credit risk assessment

Financial modeling tools can assist in assessing the creditworthiness of customers and evaluating the risk of bad debts. By integrating credit scoring models, historical data analysis, and external data sources, you can develop comprehensive credit risk models within the financial modeling tool. This helps in making informed decisions about credit approvals, setting credit limits, and monitoring customer payment behavior.

Portfolio analysis

Financial modeling tools enable you to analyze your accounts receivable portfolio and identify potential areas of concern. You can segment customers based on their payment history, outstanding balances, industry, or other relevant factors. By visualizing and analyzing the data, you can identify customers with higher risk profiles and implement targeted credit management strategies, such as intensified collection efforts or stricter credit terms.

Reporting and visualization

Financial modeling tools provide robust reporting and visualization capabilities. You can generate customized reports, dashboards, and charts to monitor key metrics related to bad debt, such as aging analysis, bad debt provision ratios, and collection performance. Visual representations of data facilitate better understanding and communication of bad debt trends and enable timely decision-making.

You can sign up to the free trial of Brixx in order to see all of these features in action.

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