What Is a Bad Debt?

What Is a Bad Debt?

By Charles Joseph | Editor, Financial Affairs
Reviewed by Corey Michael | Senior Financial Analyst

A bad debt is money owed to a business or individual that is not likely to be paid. This can occur when the debtor becomes insolvent or declares bankruptcy. In accounting, bad debts are often written off and classified as an expense since they reduce the amount of revenue a company will recognize. Essentially, when attempts to collect the money are unsuccessful and the cost of pursuing the debt is more than the debt itself, the amount is considered a bad debt.

Related Questions

1. How is bad debt written off?

Bad debts are typically written-off in two ways. The direct write-off method, where the uncollectable debt is directly removed from a company’s account receivables. Secondly, the allowance method, which makes an estimate of bad debts expected in future.

2. What’s the impact of bad debt on a company’s financial health?

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Bad debts can negatively impact a company’s financial health by reducing its total assets and net income. Too many bad debts can also scare off potential investors and lenders and might restrict a company’s ability to secure future financing.

3. Can bad debts be recovered?

Yes, sometimes bad debts can be recovered, especially if the debtor’s financial situation improves. This recovered amount is then reported as income. However, the circumstances for debt recovery are usually quite rare and difficult.

4. What’s the difference between bad debt and doubtful debt?

Bad debt is a debt that has been deemed uncollectible and is often written off. On the other hand, doubtful debt is a debt which has a high probability of turning into a bad debt, but there’s still hope for its recovery.

5. How can businesses reduce bad debts?

Businesses can reduce bad debts by conducting due diligence before extending credit, setting clear payment terms, regularly reviewing accounts receivable, following up promptly on overdue accounts, and considering using a collection agency or legal action for significant amounts.