Bad debt
Bad debt refers to any receivable or loan amount that a creditor determines is unlikely or impossible to collect from the debtor, typically due to the debtor's insolvency, bankruptcy, or unwillingness to pay, resulting in a financial loss recorded as an expense on the creditor's financial statements.[1] This expense arises primarily from credit sales or loans extended to customers or borrowers and represents a key risk in credit-based business operations.[2] In accounting practice, bad debts are managed through estimation and provisioning to adhere to the matching principle, which aligns expenses with related revenues in the same period. The preferred method under both U.S. GAAP and IFRS is the allowance method, where a contra-asset account called the allowance for doubtful accounts is established to estimate uncollectible receivables, with the bad debt expense debited accordingly.[2] Under U.S. GAAP, specifically ASC Topic 326 (Financial Instruments—Credit Losses), the Current Expected Credit Loss (CECL) model—effective for public companies since 2020—requires entities to estimate and recognize lifetime expected credit losses for financial assets measured at amortized cost, such as trade receivables, based on historical data, current conditions, and reasonable forecasts.[3] Similarly, under IFRS 9 (effective since 2018), the Expected Credit Loss (ECL) model mandates forward-looking impairment assessments for trade receivables, recognizing 12-month or lifetime ECLs depending on credit risk changes, with provisions recorded earlier than under the prior IAS 39 incurred loss model.[4] The direct write-off method, which expenses bad debts only when specific accounts are deemed uncollectible, is simpler but less preferred as it may distort periodic income.[5] For tax purposes in the United States, bad debts are deductible under Internal Revenue Code Section 166 only in the year they become wholly or partially worthless, requiring evidence of collection efforts and no reasonable prospect of recovery.[6] Business bad debts—those arising from trade or business activities, such as uncollected credit sales—are treated as ordinary losses, fully deductible against ordinary income on Schedule C or the business tax return.[6] In contrast, nonbusiness bad debts, like personal loans to non-customers, are considered short-term capital losses, deductible only to the extent of capital gains plus up to $3,000 of ordinary income annually, and must be totally worthless to qualify.[6] Accurate estimation and documentation of bad debts are crucial, as they impact reported profitability, working capital, and compliance with both financial reporting standards and tax regulations.[7]Core Concepts
Definition and Characteristics
A bad debt is an amount of money owed to a creditor that is deemed uncollectible after reasonable collection efforts have been exhausted, typically arising from a debtor's insolvency, fraudulent activities, or broader economic downturns that render repayment impossible.[6][8] This determination marks the point at which the receivable transitions from an asset to a realized loss for the creditor, reflecting the inherent risks of extending credit in commercial or lending activities.[9] Key characteristics of bad debt include specific criteria for irrecoverability, such as the debtor's declaration of bankruptcy, extended periods of non-payment despite repeated demands, or legal judgments confirming the debt's worthlessness.[10] Common examples encompass unpaid invoices for goods or services provided on credit, defaulted personal or business loans, and unrecovered advances in trade transactions.[5] Factors contributing to bad debts often stem from inadequate credit risk assessments at the outset, where lenders or sellers fail to thoroughly evaluate a debtor's financial stability, liquidity, or payment history, thereby exposing themselves to potential losses.[11] Bad debt must be distinguished from overdue debt, which involves temporary delays in payment due to cash flow issues or administrative oversights but remains potentially recoverable through negotiation or time; in contrast, bad debt is permanently irrecoverable.[12] Similarly, disputed debt arises from disagreements over the debt's validity, amount, or terms, often resolvable through arbitration, legal proceedings, or mutual agreement, whereas bad debt presupposes no such viable resolution path.[13]Doubtful Debts
Doubtful debts refer to accounts receivable where the collection of the owed amount is uncertain, typically arising from the debtor's financial instability or other indicators of potential non-payment, but not yet confirmed as uncollectible. These debts are often categorized using an aging analysis, such as those overdue by 90 days or more, which helps in identifying receivables at higher risk of default.[14][15][16] Assessment of doubtful debts involves both qualitative and quantitative methods to evaluate the likelihood of recovery. Qualitative factors include the debtor's credit history, ongoing business relationships, and external economic pressures affecting the debtor's solvency, such as industry downturns or legal disputes. Quantitative indicators encompass payment delay patterns, the ratio of overdue amounts to total receivables, and broader economic metrics like unemployment rates or sector-specific default trends that signal increased risk.[15][17][18] Common examples of doubtful debts include trade receivables from high-risk customers, such as small businesses in volatile sectors facing cash flow issues, or commercial loans extended to industries like retail during economic recessions where repayment capacity is questioned but not yet impaired. Another instance involves international trade invoices from buyers in emerging markets affected by currency fluctuations, where partial payments have been made but full settlement remains in doubt.[14][19] A key concept in classifying doubtful debts is the aging schedule, a tabular report that groups receivables by the duration they have been outstanding—typically in buckets like 0-30 days, 31-60 days, 61-90 days, and over 90 days—to prioritize those showing prolonged delays. This schedule facilitates the application of initial provisioning thresholds, where companies estimate loss rates based on historical collection data for each aging category, ensuring early recognition of potential impairments without immediate write-offs. If these uncertainties resolve into confirmed non-payment, the debts may progress to bad debts.[16][20][18]Provision for Bad Debts
The provision for bad debts serves as an accounting mechanism to estimate and reserve funds against anticipated uncollectible receivables, ensuring that financial statements reflect a realistic net value of assets under the accrual basis of accounting. By recognizing bad debt expense in the same period as the related revenues, this provision adheres to the matching principle, preventing the overstatement of accounts receivable and income on the balance sheet and income statement, respectively.[1][21] Two primary methods are commonly used to estimate the provision: the percentage-of-sales method and the aging-of-receivables method. The percentage-of-sales method calculates the provision as a fixed percentage of total credit sales for the period, typically ranging from 2% to 5% based on historical data, focusing on the income statement to estimate bad debt expense directly.[22][23] In contrast, the aging-of-receivables method categorizes outstanding receivables by age and applies escalating percentages to each bracket—such as 5% for current receivables, 10% for those 31-60 days overdue, and up to 50% for those over 90 days—to derive a balance sheet-oriented allowance that reflects the increasing risk of non-collection over time.[24][25] The journal entry to record the provision involves debiting the bad debt expense account (an income statement contra-revenue item) and crediting the allowance for doubtful accounts (a balance sheet contra-asset account). For example, if a company estimates a $10,000 provision based on the methods above, the entry would be:Debit: Bad Debt Expense $10,000
Credit: Allowance for Doubtful Accounts $10,000
This contra-asset account reduces the gross receivables to their net realizable value without directly writing off specific accounts until they are confirmed uncollectible.[22][26] Under International Financial Reporting Standards (IFRS 9), entities must recognize an impairment provision using the expected credit loss (ECL) model, which requires estimating lifetime credit losses for all financial assets measured at amortized cost, incorporating forward-looking information such as economic forecasts alongside historical data.[27][28] Similarly, U.S. Generally Accepted Accounting Principles (GAAP) under ASC 326 mandate the current expected credit loss (CECL) model, where provisions are based on reasonable and supportable forecasts of credit losses over the asset's contractual life, replacing the prior incurred loss approach with a more proactive, forward-looking estimation process.[3][29]
Accounting Treatment
Recognition and Measurement
Bad debts are formally recognized in financial records when a specific receivable is deemed uncollectible, typically after reasonable collection efforts have failed, such as unsuccessful legal actions, the debtor's bankruptcy filing, or prolonged delinquency (e.g., exceeding 180 days past due) without payment.[30][31] This determination is based on the entity's internal policies, relevant facts like the borrower's credit quality, and the length of time past due, ensuring the receivable is no longer considered recoverable.[31] Two main approaches exist for measuring bad debts: the direct write-off method and the allowance method. Under the direct write-off method, bad debt expense is recognized only when a specific account is confirmed uncollectible, directly debiting the expense and crediting accounts receivable at that point.[32] This approach is simple and aligns with tax reporting requirements but delays expense recognition until well after the related revenue is recorded, violating the matching principle and understating net realizable value in interim periods.[32][33] In contrast, the allowance method estimates uncollectible amounts in advance and records bad debt expense in the same period as the sales, creating a contra-asset account (allowance for credit losses) to reflect the net realizable value of receivables on the balance sheet.[32] This method adheres to the matching principle, providing a more accurate and timely depiction of financial position, though it requires judgmental estimates that can introduce variability.[32] US GAAP, as outlined in ASC 326 (Financial Instruments—Credit Losses), mandates the allowance method via the Current Expected Credit Loss (CECL) model for financial assets like trade receivables measured at amortized cost.[34] Under CECL, entities must recognize an allowance for expected credit losses at initial recognition, spanning the contractual life of the receivable and incorporating historical loss data, current conditions, and reasonable forward-looking forecasts (e.g., economic trends affecting collectibility).[34] As of July 2025, FASB ASU 2025-05 amended ASC 326 to provide a practical expedient for measuring credit losses on accounts receivable and contract assets, allowing entities to estimate expected credit losses without adjusting historical loss information for current conditions and forecasts in certain matrix or aging-based methods; effective for fiscal years beginning after December 15, 2025.[35] The allowance method impacts the balance sheet by presenting accounts receivable at their net realizable value, calculated as the gross carrying amount minus the estimated credit losses, thereby avoiding overstatement of assets.[32] For specific impaired receivables, measurement often involves pooling similar assets (e.g., by aging or customer risk) and applying loss rates, such as historical write-off percentages adjusted for current factors.[34] For example, if a trade receivable has a carrying amount of $10,000 and analysis indicates an expected recoverable amount of $6,500 (based on discounted expected cash flows or adjusted loss rates), the impairment loss recognized through the allowance is $3,500, reducing the net receivable to its estimated collectible value.[34] Upon confirmation of uncollectibility, the specific amount is written off against the existing allowance, with no further impact on the income statement.[32] The initial provision for bad debts serves as this reserve, which is refined here based on actual impairment assessments.[32]Write-Off Procedures
Once a debt is deemed uncollectible following the recognition and measurement process, the write-off procedure removes it from the accounts receivable balance sheet, reducing both the gross receivables and the corresponding allowance for doubtful accounts.[2] This step ensures that financial statements accurately reflect only collectible amounts, aligning with generally accepted accounting principles (GAAP) under ASC 326-20-35-8, which requires write-offs for financial assets determined to be uncollectible.[31] The write-off process begins with a thorough review of evidence confirming uncollectibility, such as repeated unsuccessful collection attempts, customer bankruptcy filings, or legal judgments indicating no recovery potential.[36] Next, internal approval is obtained from authorized personnel, often the finance department or senior management, to authorize the removal, particularly for larger amounts exceeding predefined thresholds like $3,000.[30] The core accounting entry then debits the allowance for doubtful accounts (reducing the contra-asset account) and credits accounts receivable (reducing the asset), with no impact on the income statement since the expense was previously recorded via the allowance.[2] Documentation is essential for audit compliance and includes internal memos detailing the rationale for uncollectibility, comprehensive collection history logs showing dates and methods of contact attempts, and verification from auditors or external collection agencies if involved.[30] These records must demonstrate due diligence, such as multiple written demands or phone outreach, to substantiate the write-off and support potential tax deductions.[36] Write-offs typically occur after 180 to 360 days of non-payment, or sooner upon a court judgment declaring the debt uncollectible, to balance timely financial reporting with reasonable recovery efforts.[30] This timeframe allows for exhaustive internal and external collection pursuits before final removal.[31] For example, if a $10,000 invoice is confirmed uncollectible using the allowance method, the journal entry would be:| Account | Debit | Credit |
|---|---|---|
| Allowance for Doubtful Accounts | $10,000 | |
| Accounts Receivable | $10,000 |