Bad Debt
Candlefocus EditorBad debt can occur in businesses, but it is also an issue that people face in their personal lives. When an individual has debt they cannot pay, it is termed consumer debt. This can include auto loans, student loans, credit card debt, and medical expenses.
Businesses may incur bad debt in a few circumstances. The most common circumstance is when a customer has been extended credit terms but they fail to make payments on purchase orders. In order to comply with accounting principles, the bad debt must be written off on the accounts receivable ledger. This means the customer no longer owes the full amount of the balance and it can no longer be recovered.
There are two main ways to estimate an allowance for bad debts: the percentage of sales method and the accounts receivable aging method. With the percentage of sales method, an estimate for bad debt is made as a percentage of sales for the period. It is a fairly simple calculation, but it does not use the most accurate data. With the accounts receivable aging method, customer balances are evaluated individually. This method is more accurate in predicting bad debts, as it takes into consideration the amount of time since the customer’s last payment and their past payment history.
Bad debt can be written off on both business and individual tax returns. This is greatly beneficial for businesses, as writing off bad debt reduces taxable income, thus reducing the amount of tax the company owes. For individuals, bad debt can be written off on form 1040 using Schedule C.
Bad debt is a cost of doing business and there is always a risk of default when extending credit. Knowing how to estimate bad debt is important for businesses, in order to stay compliant and reduce their tax liability. By using an effective process for estimating bad debt, businesses can identify and write off bad debt in the most accurate and timely manner.