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Bad Debt - Meaning and Examples

Last updated date: 04th Mar 2024
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An Introduction

‘Bad Debt’ is a term which you might have encountered in Accountancy. But, most importantly, do you know what is debt? Debt is the amount of borrowed money being owed. The lender (here the company) agrees to lend the money or goods on credit to its debtors (here the outsiders of the company) for an agreed interest which will be charged with the principal debt amount, now if the debtor or the outsider do not repay the company back this debt becomes ‘bad’ thus turning the debt into a bad debt!

Pretty simply isn’t it? Let us know more on bad debt but before that, we will revise the meaning of Debt. 

Meaning of Debt

Debt is the amount of money that is borrowed by one party from another party. Debt is used by many corporations and individuals as a method of making purchases in a good quantifiable amount which they could not afford under any normal circumstances. A Debt is an arrangement that gives the borrowing party permission to borrow money under the condition that the amount is to be paid back at a later date, also paid with an interest amount.

What do you mean by Bad Debt? 

Bad Debt is a claim made by an organization that the amount cannot be collected from the customer because the customer is unable to pay the amount borrowed by the organization. 

It is only agreed on terms that the borrowing party pays the amount borrowed with interest on time as discussed by both parties. 

The Debtor's inability to repay the Debt may be due to bankruptcy of an individual or organization, serious financial problems, or the Debtor's unwillingness to repay the Debt. 

The Allowance for doubtful accounts is recorded in the annual financial statements as an Allowance for doubtful accounts. 

Bad Debts Meaning and Examples

Bad Debt is that Debt that was previously receivable but now is irrecoverable from that person who was supposed to pay that Debt. This means the Debt becomes Bad as it is unpaid. The reason for this non-payment may be the cause as the Debtors either get bankrupted or have financial problems, say the problem in the collection by the creditors for various reasons which are not possible. There are various definitions for Bad Debts to occur which will depend on the type of accounting.

Types of Bad Debts

There are types of Bad Debt that can be classified, although there are no set defined types of Bad Debt yet any business can incur the same.

We may classify the Bad dents according to different types of business models in the following category -

  • Traders – A business entity that sells and purchases the goods on credit, might incur Bad Debts in case his or her customer didn’t oblige to the predefined sets of terms and conditions of the payment for the purchase of these goods.

  • Service Providers – Similarly for a trader, a service provider may also incur Bad Debt loss in case his or her client does not repay the fees after utilizing the services provided by the service providers.

  • Repayment of Loan – For a person who is engaged in providing the loans, if a receiver does not repay his or her dues, then this will also amount to Bad Debts.

  • Court Order – In case of a dispute where out of any judicial authority, an order is pronounced directing any party to pay another party but still if the party fails to repay, this will also lead to creating Bad Debts.

  • An entity that buys and sells goods with credit allows customers to accept predefined payment terms for purchasing goods. 

  • Like a retailer, a service provider may incur Bad Debt if the customer does not repay the fees for using the service provider's services. 

  • If the recipient does not repay the Debt, it also means Bad Debt to the person who provides the loan. 

  • If an out-of-court / court or judicial order is issued and a dispute is underway instructing one party to pay the other, but the party does not repay, then it is Bad Debt. 

What causes Bad Debt?

There are many reasons why you may end up with Bad Debt. In some cases, you may simply have credited the wrong customer. If so, you should tighten your lending policy so that it does not happen in the future. It is also possible that your company is the result of a fraud that was deliberately targeted by a criminal. However, in most cases the reason is simple. Due to bankruptcy or bankruptcy, the customer simply cannot pay the invoice. 

Bad Debt Example

Suppose XYZ manufactures books and sells them to retailers. Merchants will be given 30 days to pay the company XYZ after receiving the books. XYZ posts the accounts receivable on the balance sheet and records revenue. 

However, after the 30-day deadline, XYZ recognizes that the retailer will not pay. After repeated attempts, they are still not able to collect the payment and will be considered Bad Debt. 

Provision for Bad and Doubtful Debts 

The Provision for the doubtful Debts, which is also referred to as the Provision for Bad Debts or even known as the Provision for losses on the accounts of receivable, is further estimation of the amount of the doubtful Debt which will need to be written off during a particular. This is a Provision or an Allowance for the Debts which are assumed to be doubtful.

The process of strategically estimating the Bad Debt accounts that need to be written off in the future is known as the Bad Debt Provision. There are several ways to make estimates, called Provisions, some of which are required by law and some of which are strategically prioritized. One way is to understand the past performance of loans in a particular population. In this way, you can make assessments based on previous trends and use specific data to support decision making. 

Allowance for Bad Debts

An Allowance for Bad Debt is the valuation account that is used to estimate the amount of a firm's receivable which may later be ultimately uncollectible. This is also known as the Allowance for doubtful accounts. When a borrower defaults on any loan, then the Allowance for the Bad Debt account and the loan which is received is the balance that is both reduced for the book value of the loan amount.

Bad Debt Expense

A Bad Debt expense is recognized, at the time when a receivable is no longer collected as the customer is not able to fulfil their obligation to pay the outstanding Debt for the bankruptcy or other financial problems. The Companies which extend credit to their customers report these Bad Debts as an Allowance for the doubtful accounts on the balance sheet, which also provides for credit losses.

Bad Debt Reserve

A Bad Debt Reserve is the valued number of receivables that a company or financial institution does not intend to collect. This includes the business payments that become due and the loan repayments as well.

Ways to Write off a Bad Debt 

There are two main ways that you can write off Bad Debt. These methods are as follows:

  • Bad Debt Direct write-off method 

  • Bad Debt Provision method 

Bad Debts Written Off Meaning

The Debt which cannot be recovered, and also which cannot be collected from a Debtor is the Bad Debt. The process is called writing off Bad Debt. Under the direct write-off method, the Bad Debts are shown as expensed. The company credits the accounts which are receivable on the balance sheet while debiting the Bad Debt expense account on the income statement.

FAQs on Bad Debt - Meaning and Examples

1. What do you understand by the term Bad Debt written off? 

The Debt which now cannot which cannot be collected from a Debtor is what we call Bad Debt. Acknowledging that this loss has happened is called writing off Bad Debt where the Bad Debts are shown as expensed. 

2. What are the ways to write off Debt? 

There are two ways to write off Debt- 

  • Direct Write off method

  • Provision method 

3. What is the difference between good Debt and Bad Debt? 

Good Debt is the amount taken to increase your net worth and generate income then it is considered as good Debt. But if the Debt will not increase your net worth or generate any income, it means it is your loss and you are under Bad Debt. 

4. Is there any advantage to Bad Debt? 

Bad Debt cannot be of any advantage to anyone. But yes, recognizing it guarantees the right accounting at the right time. This ensures that costs are recorded during the period in which they are incurred, ensuring the principle of fitness between concepts and revenue recognition. 

5. What are the types of Bad Debt? 

Generally, it can be classified into 4 types

  • Traders or merchants 

  • Service Providers

  • Loan Repayment

  • Court Order

6. When Should Bad Debt be Written Off?

To record the bad debt expenses, we should debit the bad debt expense and give credit allowance for the doubtful accounts. This entails a credit to the Accounts Receivable for the amount which is written off and a debit to the bad debts expense account.

Bad debt can be written off using the direct write-off method or by the provision method. The first approach tends to delay the recognition of bad debt expense. This is necessary to write off the bad debt when related to the customer invoice that is to be considered to be an uncollectible debt.

7. What is Meant by Provision for Doubtful Debt?

The provision for doubtful debts is the amount that is estimated for the bad debt which will arise from the accounts receivable which have been issued but not still collected. This is identical to the allowance for the doubtful account. The provision which is used under the accrual method is that expense is recognized with probable bad debts as soon as the invoices are issued to the customers.

8. What is a Mortgage?

A mortgage is to use one's real property for a guarantee required for a loan to get the money. The debtor or the mortgagor owns the property, while the creditor or mortgagee is the owner who owns the loan. When the mortgage transaction is executed, the debtor gets the money with the loan and promises to pay the loan back.