Bad debt expense is the amount of money that a debtor owes to a creditor and is not able to pay due to a lack of finances. Companies write off bad debt, since it is not collectible.
If a company provides goods and services on credit, the amount of money it is owed is called accounts receivable. It is almost inevitable that some customers will not be able to fully pay their debt to their creditor. Such a situation might occur when a customer’s company goes bankrupt or is liquidated. As a result, that business will not be able to fulfill its financial obligations, and its creditors will not receive the money they are owed. When a creditor discovers that one of its customers has financial problems and expects that these problems might lead to non-payment, the monetary amount owed by this debtor is classified as doubtful debt. When it is certain that a part of the accounts receivable is uncollectable, it is categorized as bad debt. Bad debt is written off immediately after it has been discovered, and directly affects the credit company’s net income. However, doubtful debt can still be recovered in the future.
The accurate prediction of bad debt expenses is crucial for effective management of credit. High levels of these types of accounts suggest that a credit company works with unreliable and risky customers. To handle the situation, reserve accounts can be created to be used as an allowance for the debts that are considered doubtful. It is also important to note that some amount of a customer’s bad debt can be collected during future accounting periods. This can happen through the customer’s bankruptcy procedure or with the help of companies specializing in bad debt recovery.