What is bad debt?
Bad debt arises when a customer or borrower fails to pay and the business decides the amount is uncollectable. It is the cost of selling on credit. Once a debt is judged bad, it is removed from [accounts receivable](/glossary/accounts-receivable) and recognised as an expense.
Two methods of recording bad debt
Direct write-off method
When a specific invoice is deemed uncollectable: debit bad debt expense, credit accounts receivable. Simple, but the expense may land in a later period than the sale. It is generally not allowed under IFRS or GAAP for material amounts.
Allowance method
Estimate likely losses in advance with an [allowance for doubtful accounts](/glossary/allowance-for-doubtful-accounts). When a specific debt goes bad: debit the allowance, credit accounts receivable. This matches the cost to the period of the sale.
Signs a debt may be bad
- The invoice is far overdue, often 90 to 180 days or more.
- The customer has entered insolvency or closed.
- Repeated collection attempts have failed.
- The customer disputes the debt and recovery isn't worth pursuing.
Example
A supplier is owed $2,500 by a customer that has gone into liquidation. Using the allowance method, it writes the $2,500 off against its existing allowance. Net receivables are unchanged, because the loss was already expected.
Reducing bad debt
- Run credit checks before offering terms.
- Ask for deposits on large orders.
- Invoice quickly and chase consistently.
- Use payment links to make paying easy.