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Bad debt occasionally called Uncollectible accounts expense is a monetary
amount Quantity or amount is a property that can exist as a multitude Multitude is a term for a group of people who cannot be classed under any other distinct category, except for their shared fact of existence. The term has a history of use reaching ba ...

amount
owed to a creditor that is unlikely to be paid and for which the creditor is not willing to take action to
collect The collect ( ) is a short general prayer of a particular structure used in Christian liturgy. Collects appear in the liturgies of Roman Catholic, Orthodoxy, Orthodox, Anglican, Methodism, Methodist, Lutheran, and Presbyterian churches, among othe ...
for various reasons, often due to the debtor not having the money to pay, for example due to a company going into liquidation or insolvency. There are various technical definitions of what constitutes a bad debt, depending on accounting conventions, regulatory treatment and the institution provisioning. In the USA, bank loans with more than ninety days'
arrears Arrears (or arrearage) is a legal term for the part of a debt Debt is an obligation that requires one party, the debtor A debtor or debitor is a legal entity (legal person) that owes a debt Debt is an obligation that requires one ...
become "problem loans". Accounting sources advise that the full amount of a bad debt be written off to the profit and loss account or a provision for bad debts as soon as it is foreseen.


Doubtful debt

Doubtful debts are those debts which a business or individual is unlikely to be able to collect. The reasons for potential non-payment can include disputes over supply, delivery, the condition of item or the appearance of financial stress within a customer's operations. When such a dispute occurs it is prudent to add this debt or portion there of to the doubtful debt reserve. This is done to avoid over-stating the assets of the business as trade debtors are reported net of Doubtful debt. When there is no longer any doubt that a
debt Debt is an obligation that requires one party, the debtor A debtor or debitor is a legal entity (legal person) that owes a debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to ...

debt
is uncollectible, the debt becomes bad. An example of a debt becoming uncollectible would be:- once final payments have been made from the
liquidation Liquidation is the process in accounting by which a company A company, abbreviated as co., is a Legal personality, legal entity representing an association of people, whether Natural person, natural, Legal personality, legal or a mixture o ...
of a customer's
limited liability company A limited liability company (LLC) is the US-specific form of a private limited company A private limited company is any type of business entity in Privately held company, "private" ownership used in many jurisdictions, in contrast to a Publ ...
, no further action can be taken.


Doubtful debt reserve

Also known as a ''bad debt reserve'', this is a
contra account Debits and credits in double entry bookkeeping are entries made in account ledger A ledger is a book or collection of accounts in which account transactions are recorded. Each account has an opening or carry-forward balance, would record tr ...
listed within the
current asset In accounting Accounting or Accountancy is the measurement ' Measurement is the number, numerical quantification (science), quantification of the variable and attribute (research), attributes of an object or event, which can be used to compar ...
section of the
balance sheet In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...

balance sheet
. The doubtful debt reserve holds a sum of money to allow a reduction in the
accounts receivable Accounts receivable, abbreviated as AR or A/R, are legally enforceable claims for payment held by a business for goods supplied or services rendered that customers have ordered but not paid for. These are generally in the form of invoices An in ...
ledger due to non-collection of debts. This can also be referred to as an allowance for bad debts. Once a doubtful debt becomes uncollectable, the amount will be
written off A write-off is a reduction of the recognized value of something. In accounting, this is a recognition of the reduced or zero value of an asset. In income tax statements, this is a reduction of taxable income, as a recognition of certain expenses re ...
.


Accounting practice in different countries


United States

Allowance for bad debts are amounts expected to be uncollected but that are still possible to be collected (when there is no other possibility for collection, they are considered uncollectible accounts). For example, if
gross receivables Gross may mean coarse, unrefined, or the total amount. Gross may also refer to: *Disgust Disgust ( Middle French: ''desgouster'', from Latin language, Latin ''gustus'', "taste") is an emotional response of rejection or revulsion to somethi ...
are
US$ The United States dollar (symbol A symbol is a mark, sign, or word In linguistics, a word of a spoken language can be defined as the smallest sequence of phonemes that can be uttered in isolation with semantic, objective or pragmatics, ...
100,000 and the amount that is expected to remain uncollected is $5,000, net receivables will be
US$ The United States dollar (symbol A symbol is a mark, sign, or word In linguistics, a word of a spoken language can be defined as the smallest sequence of phonemes that can be uttered in isolation with semantic, objective or pragmatics, ...
95,000. In financial
accounting Accounting or Accountancy is the measurement ' Measurement is the number, numerical quantification (science), quantification of the variable and attribute (research), attributes of an object or event, which can be used to compare with other ob ...
and
finance Finance is a term for the management, creation, and study of money In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in the left corn ...

finance
, bad debt is the portion of receivables that can no longer be collected, typically from
accounts receivable Accounts receivable, abbreviated as AR or A/R, are legally enforceable claims for payment held by a business for goods supplied or services rendered that customers have ordered but not paid for. These are generally in the form of invoices An in ...
or
loan In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money avai ...
s. Bad debt in accounting is considered an expense. There are two methods to account for bad debt: # Direct write off method (Non-GAAP) - a receivable that is not considered collectible is charged directly to the
income statement An income statement or profit and loss accountProfessional English in Use - Finance, Cambridge University Press, p. 10 (also referred to as a ''profit and loss statement'' (P&L), ''statement of profit or loss'', ''revenue statement'', ''statemen ...
. # Allowance method (GAAP) - an estimate is made at the end of each fiscal year of the amount of bad debt. This is then accumulated in a provision that is then used to reduce specific receivable accounts as and when necessary. Because of the
matching principle In accrual accounting, the revenue recognition principle states that revenues should be recorded during the period in which they are earned, regardless of when the transfer of cash occurs. And the matching principle instructs that an expense shou ...
of accounting,
revenue In accounting, revenue is the total amount of income generated by the sale of goods and services related to the primary operations of the business. Commercial revenue may also be referred to as sales or as turnover. Some companies receive reven ...
s and
expenseExpenditure is an outflow of money, or any form of Wealth, fortune in general, to another person or group as payment for an item, service, or other category of costs. For a leasehold estate, tenant, renting, rent is an expense. For students or parent ...
s should be recorded in the period in which they are incurred. When a sale is made on account, revenue is recorded along with account receivable. Because there is an inherent risk that clients might
default Default may refer to: Law * Default (law), the failure to do something required by law ** Default (finance) In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It ...
on payment, accounts receivable have to be recorded at
net realizable value Net realizable value (NRV) is a measure of a fixed or current asset In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non ...
. The portion of the account receivable that is estimated to be not collectible is set aside in a contra-asset account called Allowance for doubtful accounts. At the end of each ,
adjusting entries In accounting/accountancy, adjusting entries are general journal, journal entries usually made at the end of an accounting period to allocate income and expense, expenditure to the period in which they actually occurred. The revenue recognition pri ...
are made to charge uncollectible receivable as expense. The actual amount of uncollectible receivable is written off as an expense from Allowance for doubtful accounts.


Taxability

Some types of bad debts, whether business or non-business-related, are considered tax deductible. Section 166 of the
Internal Revenue Code The Internal Revenue Code (IRC), formally the Internal Revenue Code of 1986, is the domestic portion of federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large The ''United States Sta ...

Internal Revenue Code
provides the requirements for which a bad debt to be deducted.


Criteria for deduction

To be considered deductible, the debt must be: *bona fide debt, and *worthless within the taxable year. A debt is defined as a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a determinable sum of money. The debt in question must also be considered worthless. This distinction is further broken down into the level of collectibles. One must determine whether the qualifying debt is completely or partially worthless. A partially worthless status means a portion of the debt may be recovered in future periods. Numerous factors are taken into consideration including the debtor’s insolvency status, health conditions, credit standing, etc.


Section 166

Section 166 limits the amount of the deduction. There must be an amount of tax capital, or basis, in question to be recovered. In other words, is there an adjusted basis for determining a gain or loss for the debt in question. An additional factor in applying the criteria is the classification of the debt (non-business of business). A business bad debt is defined as a debt created or acquired in connection with a trade or business of the taxpayer. Whereas, a non-business debt is defined as a debt that is not created or acquired in connection with a trade or business of the taxpayer. The classification is quite significant in terms of the deductibility. A non-business bad debt must be completely worthless in order to be deducted. However, a business bad debt is deductible whether it is partially or completely worthless.


Mortgage bad debt

Mortgages which may noncollectable can be written off as a bad debt as well. However, they fall under a slightly different set of rules. As stated above, they can only be written off against tax capital, or income, but they are limited to a deduction of $3,000 per year. Any loss above that can be carried over to following years at the same amount. Thus a $60,000 mortgage bad debt will take 20 years to write off. Most owners of junior (2nd, 3rd, etc.) fall into this when the 1st mortgage forecloses with no equity remaining to pay on the junior liens. There is one option available for mortgages not available for business debt - donation. The difference is that a valuation of $10,000 can be taken without an appraisal. An appraisal may be able to increase the value to more and must be based on other similar mortgages that actually sold, but generally is less than the face value. The real difference is that as a donation the amount of deduction is limited to up to 50% of Adjusted Gross Income per year with carryovers taken over the next 5 years . This is because the deduction is now classified as a donation instead of a bad debt write off and uses Schedule A instead of Schedule D . This can significantly increase current year's tax reductions compared to the simple write off. The caveat is that it must be completed PRIOR to the date of final foreclosure and loss. The process is simple, but finding a charity to cooperate is difficult since there will be no cash value as soon as the 1st mortgage forecloses.


Problem loan

In the USA, bank loans with more than ninety days' arrears become "problem loans".


References


External links


NYSSCPA's glossary
of accounting terms {{Authority control Expense Debt Accounts receivable