A bad debt, also known as a bad loan or delinquent loan, is money owed that will not be paid. The definition of a bad debt can vary from country to country, company to company, and different accounting conventions. In personal finance, bad debt refers to high-interest debt on goods bought from retailers.
In the United States, a loan with over ninety days’ arrears becomes a ‘problem loan’. Accounting experts advise companies to write off the full amount of a bad debt to the profit and loss account. They also advise businesses to make provisions for bad debts as soon as they are foreseen.
A bad debt is typically the result of the borrower going into bankruptcy. The creditor (the party that is owed money) may class a loan as a bad debt if it decides that the cost of chasing payment will be higher than the amount owed. In such cases the lender will probably write off the bad debt as an expense.
During the 2008 global financial crisis, the total value of bad debts that companies had to write off increased dramatically.
Most businesses sell their products on credit, even though some sales might be to customers with poor credit ratings. Firms that make credit sales should estimate what proportion of invoices sent out will never be paid – this can usually be found in their allowance for doubtful accounts.
The credit control department in a company determines who to offer trade credit to, as well as chasing bad debts.
Difference between a bad debt and a doubtful debt
A bad debt is money owed that has been clearly identified as not being collectible. The company’s accountant will remove that money due from the accounts receivable account.
A doubtful debt is an account receivable that could turn into a bad debt at some point in the future. For the moment, however, there is no certainty – the debtor might or might not pay.
There is no clear margin separating the two definitions. What one company may define as a bad debt another may call a doubtful debt.
The US Internal Revenue Service (IRS) says the following about bad debts:
“You have a bad debt if you cannot collect money owed to you. A bad debt is either a business bad debt or a nonbusiness bad debt. A business bad debt is a loss from the worthlessness of a debt that was either created or acquired in your trade or business, or closely related to your trade or business when it became partly or totally worthless.”
Bad debt in personal finance
In personal finance, bad debt generally means high-interest consumer debt – debt that is not beneficial in the long-term.
A mortgage is not considered as a bad debt because the mortgagor (borrower) has the potential to profit from a rise in the price of his or her home.
Credit card debt, and many credit arrangements done with purchases from retailers are bad debts, because they are taken on for consumption and interest rates are very high.
Consumer goods, unlike property, nearly always go down in value over time – so the borrower owes more on debts from their purchases than their worth.
Video – Bad Debt Expense
In this video, Kristin Ingram introduces bad debt expense and two ways to record it – direct write-off and the allowance method.