Bad Debt Definition

The allowance of doubtful accounts is a measure used by businesses to determine how much bad debt they expect to encounter.

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What is Bad Debt?

Bad Debt is that amount of money that has been lent to a person, but can no more be recovered because either the debtor has become bankrupt or has some financial inability to pay or it cannot be collected due to some other reasons.

In business, it occurs from the sales made in credit. Businesses are supposed to allow for bad debts. They are even expected to consider a certain percentage of their total credit sales to be bad debts and record this amount in their allowance of doubtful accounts which is also called provision for credit losses.

The allowance of doubtful accounts is a measure used by businesses to determine how much bad debt they expect to encounter. This helps them manage their cash flow and finances and allows them to plan for losses. It also helps them to better manage their accounts receivable.

Methods to Know Bad Debts

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1. Direct Write-Off Method

In this method, the amount that is not expected to be collected are directly written off and charged to the income statement. This method violates the matching principle of accrual concept that is used in accounting and GAAP (Generally Accepted Accounting Principles). According to this principle, a transaction should be recorded only when the transaction occurs avoiding the time of occurrence of the cash transfer.

This method is basically followed for income tax purposes as the Internal Revenue Service (IRS) allows all the debts that earlier have been reported as an income.

2. Allowance Method

No business can know beforehand that which credit sale will be a bad debt or which can be recovered. Therefore, in this method, an allowance for credit losses is created based on the predictive and approximate figures. This allowance is then used by the businesses to adjust the receivable accounts. This method follows the accrual concept of accounting.

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