When a financial institution, supplier, or vendor lends money to a customer who isn't likely to pay it back, this is called bad debt. This might happen if the borrower has money problems, declares bankruptcy, or forgets to pay. Lenders often try multiple methods to recover bad debts, including legal actions and collection efforts, but eventually may have to concede that these debts are irrecoverable.

Example of Bad Debt

Take UK Ltd., a retail company that sold PZ £10,000 worth of goods on credit, as an example. This will help to paint a clearer picture. This £10,000 becomes a bad debt for UK Ltd. when PZ files for bankruptcy and cannot pay. Differentiating between good and bad debt is essential when discussing bad debt. Bad debt usually doesn't offer any return and can be a financial burden, whereas good debt can be an investment that gains value or makes money. Additionally, the concept of bad debt adjustment is critical in financial management. It involves adjusting the value of bad debts in the financial records to reflect their likely non-recoverable status.

Two Approaches For Writing Off Bad Debt

Approach 1

When a company finds out a customer won't pay what they owe, they sometimes use a "direct write-off" method to handle this. It's like saying goodbye to that specific amount owed by the customer. This approach is straightforward: they reduce the amount in the customer's account and record it as a bad debt expense. So, if a customer can't pay $500, the company would note down a $500 bad debt expense.

There are a few issues with this approach, though. The company's earnings reports are susceptible to errors. Selling something in 2022 without knowing the customer won't pay until 2023 might lead to them making too much money. Because of this, their 2023 profits would appear lower than they were. This is why businesses only use this method for small amounts that won't significantly affect their finances. When they write off debt this way, they make two notes in their books: they increase their bad debt expense and decrease what they expect to receive (accounts receivable).

Approach 2

Another way companies handle bad debts is by guessing in advance how much they might not get paid. This is called the "allowance method." At the end of the year, they make an educated guess about how much of their total sales they might not collect. They base this guess on past experiences or overall sales. For example, if the past 2 % of sales has never been collected, they will allow 2 % of total sales to be a 'just in case' buffer or the account for doubtful sales.

It's not that they are saying these customers will certainly not pay; they're simply being prudent. They finally use this contingency fund to pay the expenses when they determine that a specific customer's debt will not be repaid. Therefore, they cut down on the allowance for doubtful accounts, and they cut down the same amount from the accounts receivable.

Estimating Bad Debt

In corporate finance, recognizing bad debts is crucial. Companies typically estimate these uncollectible amounts using two main methods: statistical analysis through Accounts Receivable (AR) aging or a percentage of net sales. Here's a simple breakdown of each.

AR Aging Method

When analyzing a company's financial health, it is essential to consider accounts receivable, especially non-collection risk. The 'Accounts Receivable Aging Method' applies a due date-based classification to receivables. Later invoices with a lower payment likelihood are given a higher percentage in this type of analysis. Think about a company whose accounts receivable are $70,000 due in 30 days and $30,000 past due. Based on past data, the company anticipates collecting 95% of new and 96% of current accounts. Hence, the realistic write-off figure amounts to $ 1,900 = ( $ 70,000 X 1 %) + ( $ 30,000 X 4 %).

But from the point of view of reporting financials, the company must write off this $ 1,900 as an allowance for doubtful accounts (acknowledged colloquially as bad debt expense). Such an amount represents the estimated losses caused by unpaid accounts, an important figure for investors and managers. It's all a matter of good debt and bad debt. Good debt is potential earnings, while bad debt is loss of money.

Three years later, it reduced the amount to US $ 2,500 of current receivables, resulting in bad debts valued at US $ 600 more. This is a bad debt adjustment within the framework of real accounting, and the figures in the financial statements reflect real debts and the real possibility of loss on bad loans. As long as companies constantly analyze and adjust their bad debts, they can see their financial stability.

Bad Debt Expenses and Sales Projections

Calculating bad debt expense based on a percentage of sales is straightforward. Companies estimate this percentage from their experience in collecting payments. For example, let us start with a company taking in $ 2,000,000 annually in revenues. Therefore, using their numbers of a past 2 % bad debt rate, they risk losing $ 40,000. That ratio is calculated by recasting their total sales over the year ( $ 2,000,000) figure by the estimated amount that is not collected (2 %).

To take a realistic example, let us study the “ case ” of a roofing company that begins a US $ 10,000 project on credit. At first, the company would just make a journal entry, raise accounts receivable by the same amount, and raise revenues. But when it is clear that the customer can't pay the US $ 10,000, the company has to make fresh calculations. To accomplish this, it offsets accounts receivable by $ 10,000 and normalizes everything by crediting bad debt expectation by the same figure. If the company is so lucky to receive half of that, say half, they will record the payment as increasing cash, decreasing bad debt expense, and reducing accounts receivable.

Good Debt vs Bad Debt

Knowing the difference between good debt vs bad debt is especially important for business leaders. The first is good debt, something that will pay off in the future. The second is the opposite of this: bad debt, which means that it is a loss. Thus, failure to make bad debt adjustments makes it impossible to get things right, and you can't report the company's financial condition correctly or fully assess it. Companies can and should constantly review their receivables and make appropriate adjustments, contributing to the management and improvement of their financial statements.