Understanding Bad Debts

Understanding Bad Debts

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Victoria Okonkwo has a background in English Language and Literature. She is an SEO expert writer with WordPress experience.

Victoria has a reputable track record of competence and skill in the crypto space, finance, and the blockchain world in general, having created 500+ SEO content for numerous clients.

She has over five years of cross-industry content and copywriting experience, a B.A. in English literature, and has completed over 500 projects.

Understanding Bad Debts

When it comes to financial understanding and business growth, one cannot overlook the aspect of bad debts. As a business owner, you should create room for issues that may lead to bad debt. 

Although no one likes or prays for bad debts, they are one of the business hard knocks that you may encounter now and then. Therefore understanding what bad debts entail can help put your business in check, so you don’t run at a loss. 

So, what do you know about bad debts? If you are a new business owner, this article will help you understand bad debts and how to estimate it in your business or orgnization. It is worth the read. 

What are Bad Debts?

Bad debts are loans or unpaid balances that must be written off because they are no longer considered recoverable. For instance, if a company supplies goods to Customer A, with an agreement to pay back at a stipulated time, and Customer A, due to one financial reason or the other, fails to meet up with the payment, the company will try other possible means of getting the money back. Then, if after all efforts to receive payment from Customer A prove abortive, the company will record that transaction as a bad debt.

For various reasons, debtors, either individuals or organizations, can fail to repay loans or credit sales.  It could result from financial bankruptcy, bad sales, or abrupt refusal to pay back their debt. In addition, business owners cannot fully guarantee the credibility of their customers when it comes to paying back debts, hence the room for bad debts.

How to Calculate Bad Debts

The two ways to calculate bad debts are:

1. Direct write-off method

In the United States, the direct write-off method is used for income tax purposes. It involves writing off irrecoverable debts. For accounts considered uncollectible, the direct write-off method keeps a precise record of the amount. 

The direct write-off method debits the account for bad debts and credits the account for receivables. However, this method of estimating bad debts violates generally accepted accounting principles (GAAP) and the accrual accounting matching principle. 

2. Allowance Method

When it involves a lot of money, this approach is preferable. With this approach, the organization prepares for the possibility of bad debts by anticipating their occurrence. 

This is accomplished by creating an allowance for doubtful accounts, a contra asset account that lowers the loan receivable account when both accounts reflect on the balance sheet.

During sales, a predetermined amount is deducted from the allowance for doubtful accounts and credited to the bad debt expense account. The allowance for doubtful accounts is debited, and the accounts receivable account is credited when businesses decide to write off bad debt.

How to Estimate Bad Debts

You can estimate bad debts using the following methods:

Percentage of Net Sales Method

One way to estimate bad debt is by taking a percentage of a company’s net sales in line with its historical records of bad debts in the past. Here, the total dollar amount of sales for the period receives a flat percentage under the sales method. 

For instance, a business might anticipate that 2% of net sales won’t be collectible based on prior performance. So if the company’s net sales for the entire period are $100,000, it sets aside $2,000 as an allowance for doubtful accounts and records an additional $2,000 in bad debt expenses. 

A total of $1,200 is added to the allowance for doubtful accounts, and $1,200 is recorded in bad debt expense if the following accounting period’s net sales reach $60,000. After these two periods, the allowance for doubtful accounts has a total balance of $3,200. 

To ensure that they align with the most recent statistical modeling allowances, businesses or companies frequently modify the allowance for doubtful accounts.

Statistical Modeling

To determine a company’s anticipated losses, you can estimate bad debt expense using statistical modeling, such as default probability. The statistical calculations make use of historical data from the company as well as from the industry at large. 

The specific percentage will typically rise as the receivable gets older, reflecting a rising default risk and a declining likelihood of being collected.

Special Considerations

Suppose a bad debt was previously reported as income, the Internal Revenue Service (IRS) permits businesses to write it off on tax Form 1040, Schedule C. Loans to customers and suppliers, credit sales to customers, and business loan guarantees can all be considered bad debt. However, unpaid rent, salaries, or fees don’t fall under deductible bad debt.

Also Read – What is DAO? Decentralized autonomous organization

If a person has previously included the money in their income or has loaned out cash and can show that they intended to make a loan and not a gift at the time of the transaction, they may also be able to deduct a bad debt from their taxable income. The IRS categorizes non-business bad debt as short-term capital losses.

Conclusion

Bad debts are inevitable in the business world. An understanding of what it entails and how to estimate bad debts can help manage financial losses in a business. 

Bad debts are irrecoverable and, as such, written off by a company or an organization. Therefore, when giving out a loan or credit, ensure to check the creditworthiness and history of the individual or organization.

+ posts

Victoria Okonkwo has a background in English Language and Literature. She is an SEO expert writer with WordPress experience.

Victoria has a reputable track record of competence and skill in the crypto space, finance, and the blockchain world in general, having created 500+ SEO content for numerous clients.

She has over five years of cross-industry content and copywriting experience, a B.A. in English literature, and has completed over 500 projects.