When an account or trade receivable i.e. a debtor turns uncollectible, it is termed as bad debts. It means he doesn’t pay the money due.
Businesses that give credits or loans to customers should always have a contingency plan, as such credits incorporate the risk of becoming bad debts.
Introduction to the Bad Debts Concept
One of the most important ways of making sure that the impromptu purchases are a part of your business is to extend certain credit to the customers. This way. The business makers will be able to boost their sales and then also increase the profits that they want to have.
However, there are some unfortunate cases where the customers aren’t able to pay off the credit, and that can be a problem in most of the cases.
Meaning of Bad Debts
The situation where the customer isn’t able to pay off the credit provided to them is known as bad debt. In this article, we are going to talk a little bit about bad debt and how it can affect the business. For those who want to know about the bad debt, this is the perfect place to be.
What Exactly are Bad Debts?
After a little discussion about the bad debt, we are here to tell you a little bit more about bad debt and how it can affect the business of the person. In the case of bad debt, the customer will owe you the money but will not be able to pay you back.
Hence, you are not able to collect the money that the customer owes you. The debt will become a bit worthless, and you will not be able to collect the money that the person owes you.
So, in a way, you will have to write the debt as something that is uncollectible.
In the business world these days, it is a very common scenario that happens when they are extending large amounts of credit to the customers, and in the process, chances of bad debts also keep on increasing.
Do you want us to give you an example here?
Example of Bad Debts
Let us begin by saying that you made a proper sale with the customer for about $800. However, the customer makes use of the store credit that is provided by the business that you have.
After offering an invoice to the customer again and again without really getting the payment back, you realize that the debt that you owe them has then become a bad one. Some creditors are able to provide the bad debt on account of yours.
In case you are not paying the money for some purchases that you make from a vendor, then the vendor will have a bad debt, which is not paid on time.
When we talk about the reason for the bad debts, it can be said that there are many different reasons for that to happen.
The customers might not have the money to pay the debt that they have. Also, there are some cases when the customers are not really happy with the products that they have been provided with, and then they might refuse to pay for the services and the product.
Let us have a look upon some of the key reasons for the bad debt-
Key Reasons for Bad Debts Occurrence
- Because of the bad financial management of the debtors, they could not pay the debt timely
- Because of the unwillingness of the debtors, bad debts occur more frequently
- Because of the inability of the creditors in collecting the debts
- Because of some sorts of dispute or issues between both the parties due to delivery, price, credit term, product and so on
- Because debtor has declared the bankruptcy
- Because choosing collection attempts may cost more than the debit
In addition, when any businesses write off bad debt as an expense, it further reduces the taxable income of that business.
Bad Debt versus Doubtful Debt
Most people might confuse the bad debt with doubtful debt, and that is something that is a very common cause for the people. However, these are very different terms, and it is important for people to know all about it.
The doubtful debt is a case where the people have a doubt whether the debt will turn into bad debt or not. This type of debt is not really uncollectible, and there is still some hope that the vendor will be able to get the money back.
Unlike bad debt, where there is no chance of payment, doubtful debt provides some hope to the people that their money might be able to come back with time.
There are many businesses that credit heir certain sales as the doubtful debt so that the finances that they have don’t really take a hit when it comes to the payment of the customers. However, the business does make a prediction that the debt will be unpaid with time.
When Does A Debt Become A Bad One?
It can be a difficult thing to find out the exact time when a particular debt will turn into a bad one.
You might think that there is a switch which will change a particular debt into a bad one, but that is definitely not the case. But in order to find out whether the debt of yours is a bad one or not, there are some things that you can try out.
In some cases, the vendor might just exhaust all the options for the customer to pay the amount back and in such cases, the debt that is on the vendor can actually become a bad debt for sure.
We have an example here that would prove the point that we are trying to make here. Say you have made several attempts in order to make some contact with the customer and it doesn’t have any response from the other end.
Also, there are some cases where you might have offered some sort of negotiation for the payment as well.
However, the debt payer doesn’t really want to pay the money that you owe them. These are some of the cases when you can consider that your debt has turned into a bad one, and this is the time to consider your money as uncollectible.
Bad Debts Vs. Good Debts
You can understand Good Debts to those loans that are certain to get collected back.
This situation occurs when debtors are punctual in paying their debts on time. In another case, if creditors are sure of receiving the amount back, it is considered as Good Debts.
While on the other hand, creditors are never sure of receiving the loan back in bad debts. Because of such issues with bad debts, there accounting is very important. In the next section, we will be discussing two methods of accounting bad debts, so let us delve into those-
Methods of Accounting for Bad Debts
#1. Direct Write-Off Method of Accounting Bad Debts
This method removes the irrecoverable amount from the Accounts Receivable and records that into Bad Debts Expense.
#2. Allowance Method of Accounting Bad Debts
This method is used for the estimation of the amount that won’t be received and then based upon that estimation; it will credit the Allowance for Doubtful Accounts, and simultaneously, it will debit Bad Debts Expense.
How to Calculate the Bad Debts
To calculate the percentage of bad debts, you need to use below given formula-
(Amount of bad debt ÷ Total Accounts Receivable) * 100
Let us understand this with an example-
Imagine a business sells $100 million worth of products on credit in a year, and $2 million of $100 million becomes uncollectible, then the percentage of bad debt would be 2%.
Percentage of Bad Debt = ($2million ÷ $100 million) * 100 = 2%
It is suggested that the bad debt rate of your company should be below 1%. Otherwise, you should be taking a few steps for securing your business.
Now, you need to know about some of the steps that can help you secure your receivables and decrease the bad debts rate.
How to secure your receivables to resolve Bad Debts Issues
Below given steps will help you in securing your receivables from becoming into bad debts-
- Setting a credit limit
- Defining the payment terms related to down payments, payment delays, etc.
- Having guarantees such a banks or credit insurance or choosing contractual clauses for reducing the chances of unpaid invoices
These methods can further be divided into two different categories-
#1. Specific Method for particular business or client
- Payment in advance
- Bank guarantees
- Delegation of payment
- Documentary credit of Letter of Credit Standby
- Parent company guarantee
#2. Generalist Methods for all the clients
- Credit insurance
- Contractual clauses
Wrapping it up!
So, that is all you need to know about bad debt. We hope that this article was a bit informative for you and has provided you with the information that you want to have.
In case of any doubts about the bad debts, feel free to ask us in the comment below.
Have you ever faced the bad debts sorts of situations? Share with us as well.