Bad Debt Reserve: Explanation, Use as Financial Health Indicator

bad debt definition

Going into debt may be beneficial to your overall financial health in several types of scenarios. The allowance method is mostly used by business entities to cater the large material amounts. The contra-account of ‘Provisions for doubtful debt’ is created in this method. The matching principle of GAAP is violated in the direct write-off method. The matching principle implies that the expenses related to certain revenues must be recorded against the same revenues.

bad debt definition

In financial accounting and finance, bad debt is the portion of receivables that can no longer be collected, typically from accounts receivable or loans. The allowance method is an accounting technique that enables companies to take anticipated losses into consideration in its financial statements to limit overstatement of potential income. To avoid an account overstatement, a company will estimate how much of its receivables from current period sales that it expects will be delinquent. In this article, we have tried to comprehend the accounting for doubtful and bad debts. Recording and recognition of bad debts and doubtful debts are very critical to the company’s financial position.

What Is Bad Debt in Accounting?

Any action taken with regard to a bad debt must be noted in the company’s books. For companies that offer debt securities and lines of credit to consumers and corporate borrowers, defaults on financial obligations – akin to irretrievable receivables – are an inherent risk to their business model. The term bad debt could also be in reference to financial obligations such as loans that are deemed uncollectible. The “Allowance for Doubtful Accounts” is recorded on the balance sheet to reduce the value of a company’s accounts receivable (A/R) on the balance sheet. Usually, the recognition of the bad debt expense can be found embedded within the selling, general and administrative (SG&A) section of the income statement.

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Alternatively, a bad debt expense can be estimated by taking a percentage of net sales, based on the company’s historical experience with bad debt. Companies regularly make changes to the allowance for credit losses entry, so that they correspond with the current statistical modeling allowances. For example, the debtors’ business is bankrupt due to Covid-19 and they could not effort to pay off its debt that is own to the company.

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As the transaction occurs, the Retailer account receivable is debited to the balance sheet, and sales are credited in the income statement. Bad debt expense is the way businesses account for a receivable account that will not be paid. Bad debt arises when a customer either cannot pay because of financial difficulties or chooses not to pay due to a disagreement over the product or service they were sold. It is possible that a customer will pay extremely late, in which case the original write-off of the related receivable should be reversed, and the payment charged against it.

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On the other end of the spectrum, the company may pay out its reserves now to give off a weaker current condition. Future performance would look better, in contrast, because the estimate for doubtful accounts would appear lower. Similarly, if some or all of the debt is recovered, you must reverse this loss. If a business recovers some or all of a bad debt, it will report the recovered funds as part of its gross income for that year.


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, you’ll debit the bad debt expense for the amount of the write off and credit the accounts receivable asset account for which transactions affect retained earnings the same amount. For accounting purposes, the bad debt reserve allows the company or bank to state the face value of its receivables or loans. The reserve resides in a different area of the balance sheet, so the net result is that the value of receivables/loans reflects their expected value.

  • The exact amount of the bad debts is deducted from the reserve account.
  • Yes, legal implications may exist depending on the circumstance in which the debt was incurred and/or not paid back.
  • Consider a roofing business that agrees to replace a customer’s roof for $10,000 on credit.
  • The allowance method is mostly used by business entities to cater the large material amounts.
  • The aging method groups all outstanding accounts receivable by age, and specific percentages are applied to each group.

You must deduct a nonbusiness bad debt during the year it becomes uncollectable. To report a nonbusiness bad debt, you’ll fill out Part 1, Line 1 of Form 8949, Sales and Other Dispositions of Capital Assets. Having a set strategy for accounting for bad debt can streamline your organization and ensure all accounts comply with local provisioning standards. One example in Financial Accounting centers on a credit provider in India that typically provisions two or three percent higher than the minimum regulatory requirement for Indian companies.


Then, you can work toward identifying which debt you should pay down first and allocate your extra funds toward that debt. Katrina Ávila Munichiello is an experienced editor, writer, fact-checker, and proofreader with more than fourteen years of experience working with print and online publications. Erika Rasure is globally-recognized as a leading consumer economics subject matter expert, researcher, and educator. She is a financial therapist and transformational coach, with a special interest in helping women learn how to invest.

You can do this yourself, or use a third-party negotiator (usually called a credit counselor). This person or company works with your lenders to negotiate lower interest rates and combine all your debt payments into one monthly payment. If you are carrying debt, you can develop a budget of your income and expenses to help ensure that you can afford all of your monthly payments. These examples are programmatically compiled from various online sources to illustrate current usage of the word ‘bad debt.’ Any opinions expressed in the examples do not represent those of Merriam-Webster or its editors. It is done based on probability by creating a provision or allowance for doubtful debts.

Bad debt provision

The matching principle of GAAP also implies recording related expenses and revenues within the same financial period. The original journal entry for the transaction would involve a debit to accounts receivable, and a credit to sales revenue. Once the company becomes aware that the customer will be unable to pay any of the $10,000, the change needs to be reflected in the financial statements.

However, many other kinds of debt are not as healthy for your finances. For the direct write-off method, the following entries will be passed in the books of accounts. We’ve helped hundreds of hospitals and medical groups with their revenue cycle issues—experience we can deploy to solve your organization’s unique challenge. Ask a question about your financial situation providing as much detail as possible. The second benefit is a margin for error with regard to planning cash flows. If the company is prepared for default, then it will not be as affected by it.

Why do bad debts happen?

Many people believe that having no debt is ideal, but in many situations, debt can actually be considered good for your finances if it helps you build wealth. For example, if you cannot afford to buy a home with cash, you may go into debt with a mortgage. That, in turn, can help you use your housing payments to build a real estate asset instead of renting. Let’s suppose the company had recognized the bad debts of $450 for the year 2020.

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