Bad debt

A debt that is not collectible and therefore worthless to the creditor. This occurs after all attempts are made to collect on the debt. Bad debt is usually a product of the debtor going into bankruptcy or where the additional cost of pursuing the debt is more than the amount the creditor could collect. This debt, once considered to be bad, will be written off by the company as an expense.

Investopedia Says:
Most companies make sales on credit as it generally allows them to increase their sales, even though some sales are to customers with less than desirable credit. Companies that do make credit sales will estimate the amount of sales they expect to lose to bad debt, which is found in the allowance for doubtful accounts.

A debtor with a history of bad debts will see their credit rating decline, which makes it difficult for the debtor to access any additional form of credit.

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Banks and Corporations: open account balance or loan receivable that has proven uncollectible and is written off. Traditionally, companies and financial institutions have maintained a Reserve for uncollectible accounts, charging the reserve for actual bad debts and making annual, tax deductible charges to income to replenish or increase the reserve. Companies and large banks ($500 million or more in assets) must generally use the direct charge-off method for tax purposes, although bad debt reserves continue to appear on balance sheets for reporting purposes. Small banks and thrift institutions continue using the reserve method for tax purposes, although with strict limitations. The relationship of bad debt Write-Offs and recoveries to accounts receivable can reveal how liberal or conservative a firm's credit and charge-off policies are.

Individuals: Individuals lending money may deduct bad debts on their tax return when the debtor does not repay the loan. Bad business debts are fully deductible from gross income on Schedule C for self-employed individuals. Nonbusiness bad debts can be deducted as short-term capital losses on Schedule D. These short-term losses can offset capital gains plus $3,000 of other income. Any excess bad debt losses can be carried forward into future tax years. In order to determine whether a bad debt deduction is legitimate:

1. the debt must be legally valid

2. A debtor-creditor relationship must be formalized at the time the debt arose

3. the funds providing the loan must have previously been reported as income or part of the individual's capital and

4. the individual must prove that the debt became worthless in that tax year.

Customer failing to pay for the merchandise or service received; also called bad pay. In the case of magazines, two or three issues are usually sent before service is suspended because of nonpayment. See also bad-debt allowance; deadbeat.

Provision for known claims due but not paid, known claims not yet due, and provision for Incurred But Not Reported (IBNR) claims. The critical problem facing a casualty insurance company is the amount of reserves necessary for the incurred but not reported losses (IBNR) because many of these claims and their resultant settlements may not manifest themselves until several years in the future. This is known as the tail end distribution liability. See also Full Preliminary Term Reserve Plan; Prospective Reserve; Reserve Liabilities Regulation; Retrospective Method Reserve Computation.

A debt that becomes uncollectable due to the debtor's refusal to pay or due to insolvency. The term is used primarily in financial accounting. For tax purposes, non-business bad debt is deductible from gross income as a short-term capital loss whereas a business bad debt is allowable as a deduction against ordinary income. I.R.C. §166.

bad debt reserve [repealed] formerly meant: rather than take deductions for specific debts that become worthless during the taxable year, a taxpayer may deduct in each year a reasonable percentage of receivables which percentage then becomes an addition to the reserve for bad debts. For example, if a taxpayer determines that on the average 3 percent of the accounts receivable become worthless during the taxable year, the taxpayer may deduct 3 percent and add it to the reserve for bad debts. I.R.C. §166(c) [repealed].

non-business bad debt is a debt that is neither (1) created or acquired in connection with the taxpayer's trade or business; nor (2) incurred in a transaction entered into for profit.

A professional fee that is owed but is not recoverable by the normal procedure of submitting three accounts at one month intervals and rendered from the veterinarian's office. A bad debt must be written off as a loss or placed in the hands of a professional debt collector or a solicitor to collect. If bad debts exceed 2% of the gross income the management of the practice should be investigated.

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