What is Bad Debt?

Published by Thomas Herold in Banking

'Bad Debt' is explained in detail and with examples in the Banking edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Bad debts are those accounts receivable that simply can not be collected. Once businesses make the determination that they are not likely to be able to collect on such sums, then they actually write these off as complete losses for the company. A debt is not typically deemed to be un-collectable until every effort within reason has been made to collect on the debt that is owed. This status is not typically reached on a debt until the person or firm owing the debt has filed for bankruptcy. Another reason for a debt to be declared a bad debt would be when the costs of continuing to collect on the debt are greater than is the amount of the debt in question.

Such bad debts commonly show up on a company income statement as an expense. This actually reduces the company’s net income. At this point, bad debts have been completely written off via crediting the account of the debtor. This cancels out any remaining balance on the debtor’s account. Such bad debts prove to be money that has been totally lost by a firm. Because of this, these kinds of bad debts are referred to as expenses for a business.

Companies attempt to estimate their expenses in the form of bad debts using records from similar past time frames. They look to figure out how many bad debts will show up in the current time frame based on what happened before so that they can attempt to estimate their actual earnings. The majority of corporations come up with an allowance for bad debts, as they understand that a percentage of their debtors will never repay them completely. Banks and credit card companies are especially concerned with bad debt allowances, since much of their entire business model revolves around the issuing of credit and repayment of debts from businesses and individuals.

The real difficulty with bad debts lies in determining if and when they are actually dead. When a debtor disappears, the collateral is destroyed, a lawsuit statute of limitations expires, bankruptcy is discharged, or significant pattern of a debtor abandoning debts is present, then a debt is finally determined to be bad debt. These can be subjective measurements in some cases.

Income tax laws contain a different definition for bad debts. These debts can be deducted against regular income on a 1040 C Form. These personal debts are also able to be deducted against short term types of capital gains. Debts that are owed for services which have been rendered to a person or business are not considered taxing purpose bad debts. This is because no income is present for such unpaid services that can be taxed.

Where individuals are concerned, bad debt can refer to credit card debt or any other form of high interest debt. These kinds of debts take away money from the individual in interest payments every month, creating a negative cash flow. Good debt for an individual would be debt that is used to properly leverage investments. Such leveraged investments that create positive cash flow prove to be the most desirable forms of debt.

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The term 'Bad Debt' is included in the Banking edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.