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Bad debt

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Bad debt
A bad debt is an amount owed to a business or individual that is written off by the creditor as a loss (and classified as an expense) because the debt cannot be collected and all reasonable efforts to collect it have been exhausted. This usually occurs when the debtor has declared bankruptcy or the cost of pursuing further action in an attempt to collect the debt exceeds the debt itself. [1] [2] [3] The debt is immediately written off by crediting the debtor's account, eliminating any balance remaining there. The crediting represents a loss to the creditor.

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 thereof 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 is uncollectible, the debt becomes bad. An example of a debt becoming uncollectible would be:- once final payments have been made from the liquidation of a customer's limited liability company, no further action can be taken.

Doubtful debt reserve
Also known as a bad debt reserve, this is a contra account listed within the current asset section of the balance sheet. The doubtful debt reserve holds a sum of money to allow a reduction in the accounts receivable 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.

US accounting practice
Allowance for bad debts are amounts expected to be uncollected, but still with possibilities of being collected (when there is no other possibility for them to be collected, they are considered as uncollectible accounts). For example, if gross receivables are $100,000 and the amount that is expected to remain uncollected is $5,000, net current asset section of balance sheet will be:
Gross accounts receivable Less: Allowance for bad debts Net receivables $100,000 $5,000 $95,000

In financial accounting and finance, bad debt is the portion of receivables that can no longer be collected, typically from accounts receivable or loans. Bad debt in accounting is considered an expense. There are two methods to account for bad debt: 1. Direct write off method (Non-GAAP) - a receivable which is not considered collectible is charged directly to the income statement. 2. 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 which is then used to reduce specific receivable accounts as and when necessary. Because of the matching principle of accounting, revenues and expenses 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 on payment, accounts receivable have to be recorded at net realizable

but they are limited to a deduction of $3. The debt in question must also be considered worthless.[6] Most owners of junior (2nd. A partially worthless status means a portion of the debt may be recovered in future periods. in question to be recovered. 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 . the debt must be: • bona fide debt. This distinction is further broken down into the level of collectibles.donation. 2 Taxability Some types of bad debts. etc. 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. and • worthless within the taxable year. At the end of each accounting cycle. Any loss above that can be carried over to following years at the same amount.000 mortgage bad debt will take 20 years to write off. health conditions. The actual amount of uncollectible receivable is written off as an expense from Allowance for doubtful accounts. whether business or nonbusiness related. they can only be written off against tax capital. or income.000 can be taken without an appraisal. Mortgage Bad Debt Mortgages which may become noncollectable can be written off as a bad debt as well. In other words. credit standing. they fall under a slightly different set of rules. 3rd.[7] 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 .[4] Criteria for deduction To be considered as deductible. Numerous factors are taken into consideration including the debtor’s insolvency status. The classification is quite significant in terms of the deductibility. is there an adjusted basis for determining a gain or loss for the debt in question. a nonbusiness debt is defined as a debt that is not created or acquired in connection with a trade or business of the taxpayer. A nonbusiness bad debt must be completely worthless in order to be deducted. However. but generally is less than the face value. The difference is that a valuation of $10. are considered tax deductible. As stated above.) fall into this when the 1st mortgage forecloses with no equity remaining to pay on the junior liens.000 per year. An appraisal may be able to increase the value to more and must be based on other similar mortgages that actually sold. An additional factor in applying the criteria is the classification of the debt (nonbusiness or business). One must determine whether the qualifying debt is completely or partially worthless. a business bad debt is deductible whether it is partially or completely worthless. There is one option available for mortgages not available for business debt . Thus a $60. etc. Section 166 of the Internal Revenue Code provides the requirements which for a bad debt to be deducted. or basis. 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. There must be an amount of tax capital. adjusting entries are made to charge uncollectible receivable as expense.[5] Section 166 Section 166 limits the amount of the deduction. A business bad debt is defined as a debt created or acquired in connection with a trade or business of the taxpayer. Whereas.Bad debt value. However.

pdf) [7] Pub.nysscpa.526. au/ osbuyers/ glossary.[6] This can significantly increase current year's tax reductions compared to the simple write off. com/ Bad+ Debt TaxAlmanac . irs. The caveat is that it must be completed PRIOR to the date of final foreclosure and loss. Publication 526 Charitable Contributions (http:/ / www. Bad debts (http:/ / www. thefreedictionary. irs. php/ Internal_Revenue_Code:Sec. _166. taxalmanac.Topic 453 Bad Debt Deduction (http:/ / www.Internal Revenue Code:Sec. _Bad_debts) [5] Tax Topics . html) [6] Form 1040. IRS Instructions for Schedule A (Form 1040) (http:/ / www. htm http:/ / www. gov/ taxtopics/ tc453.Bad debt . irs.svtuition. 3 References [1] [2] [3] [4] http:/ / www. allbusiness. co http:/ / financial-dictionary. but finding a charity to cooperate is difficult since there will be no cash value as soon as the 1st mortgage forecloses.org/2009/11/how-to-teach-concept-of-debtors-bad. com. gov/ pub/ irs-pdf/ i1040sd.org/glossary) of accounting terms . The process is simple. org/ index. apm. 166. pdf) External links • Bad Debts (http://www.html) • NYSSCPA's glossary (http://www. gov/ pub/ irs-pdf/ p526.

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