What Is Bad Debt
In simple words, debt is the amount of money borrowed by one party from another. It is the fundamental part required in making large purchases that many corporation and individual cannot afford under normal circumstances. However, not all debts are same. There is good as well as bad debt. Good debt is what will be repaid within the given timeframe. On the other hand, bad debt is the money lost. Such type of debt needs to be written off. So, let’s learn more about what exactly bad debt is.
Bad debt can emerge due to various reasons. It could be due to lending a loan to customer who is not responsible with their repayment. It could also be due to fraud which is likely to lead the customer to bankruptcy and insolvency. At times, such bad debt are able to be collected, but most of the time, the cost of pursuing the debt might outweigh the value of recovering the debt.
Accounting Practices For Bad Debt
To manage bad debt two types of accounting methods are used. The first method involves providing in advance for bad debt so that it can mitigate the financial impact in advance. This approach is known as allowance method. Typically, the companies create a doubtful debt reserve of finances. These reserve finances acts as a contra, balancing the assets of the business so that throughout the financial year the balance sheet remains as accurate as possible. By providing for bad debt, companies will be in a better position to manage their own finances and prevent any sort of supply chain corruption.
The second accounting method is more reactive compared to the allowance method. In this method, once a doubtful debt becomes bad debt, it is immediately charged to the income statement directly. This method is known as direct write-off method. Many find this method more accurate as it does not involve guessing the volume of debt. Under this method businesses are less to mitigate debt in advance.
Tax Deductible Bad Debt
Bad debt is highly dangerous for businesses. But it can at times be tax deductible. However, all debt has to be recorded and written off so that they can be tax deductible. Besides, all reasonable attempts should have been made to recover the debt. If the debt is of a considerable amount, businesses should take the necessary legal action before declaring the debt bad. It is also possible to claim a debt deduction that was partially written off. However, such debts owed by related parties such as business partner, family members or shareholders, cannot be tax deductible.
Impacts Of Bad Debt
The impact of bad debt can be devastating. Right after the financial crisis, bad debt has rippled all across the globe, forcing banks, business and governments to act out debt write offs. According to The Money Charity, in 2015, the UK banks and building societies has written off £3.175 billion of loans to individuals. The very first quarter of 2015, £1,046 million debt was written off that equates to £11.4 million of debt written off every day.
In order to avoid a bad debt write off and bad debts it is important that one checks credit worthiness. One should have a clean history of repayment. Such assessment is called as checking a company’s ‘credit worthiness’. Besides, a company should have a proper debt collection procedure in order to prevent debts getting out of hand. They should also set out stricter terms, arrange for prepayments and hold solid proof of agreement. Many companies are legally entitles to charge extra fee as well as interest on late payments, in order to deter customers from making late payments. Besides, by scheduling a reminder a few days ahead of payment is another effective way to avoid late repayment. Setting up such reminder will also help to build a good relationship between companies and client and also it will ensure timely transactions.