Bad Debt

When a business sells on credit, some customers will inevitably fail to pay. They may go out of business, dispute the bill or simply disappear. The amount that cannot be collected becomes bad debt, and it is recorded as an expense because it reduces the value the business actually receives from its sales.

There are two main ways to record bad debt. Under the direct write-off method, the debt is removed only when it is clearly uncollectable. Under the allowance method, which accounting standards generally require for larger businesses, the company estimates in advance how much of its receivables will go unpaid and records that expense in the same period as the sales.

For example, if a company has 200,000 of receivables and past experience suggests about 3% will not be collected, it records a bad debt expense of 6,000 and an allowance of the same amount.

Bad debt is a normal cost of selling on credit. Businesses manage it by checking customers' creditworthiness, setting credit limits, chasing overdue payments promptly and sometimes asking for deposits.