What is bad debt?
When you first hear about the term bad debt, you may think, but wait, isnt all debt bad? Absolutely not  debt is a fundamental part of business, and just as you can have bad debt, you can have good debt too. If youve got receivables that will be repaid at an agreed-upon time, possibly with interest, youre dealing with good debt. However, if its no longer possible to collect on your receivables, youre going to need to know how to deal with the bad debt on your books. Weve got you covered. Bad debt meaning  Simply put, a bad debt is a type of expense that occurs after repayment by a customer (when credit has been extended) is no longer considered to be collectable. In other words, bad debt is an irrecoverable receivable. Any businesses that extend credit to their customers must account for the possibility of bad debt, as theres always a chance that your customers circumstances will change and they wont be able to complete payment as agreed. There are a broad range of reasons why you may end up dealing with a bad debt. In some cases, you may have simply extended credit to an unsuitable customer. If this is the case, you should look to tighten up your credit policy to stop it from happening in the future. It could also be the result of fraud wherein your business has been deliberately targeted by criminals. In most cases, however, the reason is simple: the customer simply cannot pay your bill due to insolvency or bankruptcy. How to record a bad debt  There are two main ways that you can record a bad debt in accounting. These methods are as follows:  Bad debt write-off  Bad debt provision  Its important to note that the bad debt write off method doesnt adhere to the matching principle associated with generally accepted accounting principles (GAAP). Therefore, if youre using GAAP for accounting, youll need to use the bad debt provision method instead. Some countries such as those in the UK use international financial reporting standards (IFRS) instead of GAAP, but its important to remember that the way you record bad debt expenses may differ depending on the country youre based in. Heres a little more information about these accounting methods of recording bad debt expenses:  Bad debt write-off method explained  Bad debt write-offs are used when you have a specific and recognisable bad debt on your accounts, i.e. you know that the debt is irrecoverable. In the bad debt write-off method, youll debit the bad debt expense for the amount of the write off and credit the accounts receivable asset account for the same amount. Bad debt provision method explained  A bad debt provision or allowance, also known as a provision for doubtful debts, is an accounting method that requires you to estimate the amount of bad debt that youll need to write off in any given period. In essence, youll charge an estimated amount of accounts receivable to bad debt expense, before debiting the bad debt expense for the estimated amount of the write-off. Finally, youll credit the same amount to the bad debt provision contra account. Thriving businesses can run into difficulty at the drop of a hat, and reliable customers who always pay their debts can become problematic non-payers within a relatively short space of time. As a result, its always important to be prepared to deal with bad debt expenses. Furthermore, businesses are judged by potential investors on their financial statements, which means that a bad debt could make your business look like it isnt doing as well as it is in reality. Consequently, its important to classify bad debts as bad debts so that investors can see that all your accounts are in good order. We can help  GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.