Bad debt

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A bad debt is an amount that is written off by the business as a loss to the business and classified as an expense because the debt owed to the business is unable to be collected, and all reasonable efforts have been exhausted to collect the amount owed. This usually occurs when the debtor has declared bankruptcy or the cost of pursuing further action in an attempt to collect the debt exceeds the debt itself. ^{[1] [2] [3]}

The debt is immediately written off by crediting the debtor's account and therefore eliminating any balance remaining in that account. A bad debt represents money lost by a business which is why it is regarded as an expense.

Doubtful debt

Doubtful debts are those debts which a business or individual is unlikely to be able to collect. The reasons for potential non payment can include disputes over supply, delivery, and conditions of goods or the appearance of financial stress within a customer's operations. When such a dispute occurs it is prudent to add this debt or portion thereof to the doubtful debt reserve. This is done to avoid over-stating the assets of the business as trade debtors is reported net of Doubtful debt. When there is no longer any doubt that a debt is uncollectible the debt becomes bad. An example of a debt becoming uncollectible would be:- once final payments have been made from the liquidation of a customer's limited liability company, no further action can be taken.

Doubtful debt reserve

Also known as bad debt reserve, this is a contra account listed within current asset section of the balance sheet. Doubtful debt reserve will hold a sum of money to allow a reduction in the accounts receivable ledger due to non-collection of debts. This can also be referred to as the allowance for bad debts. Once a doubtful debt becomes uncollectable, the amount will be written off.

US accounting practice

Allowance for bad debts are amounts expected to be uncollected, but still with possibilities of being collected (when there is no other possibility for them to be collected, they are considered as uncollectible accounts). For example, if gross receivables are $100,000 and the amount that is expected to remain uncollected is $5,000, net current asset section of balance sheet will be:

In financial accounting and finance, bad debt is the portion of receivables that can no longer be collected, typically from accounts receivable or loans. Bad debt in accounting is considered an expense.

There are two methods to account for bad debt:

1. Direct write off method (Non-GAAP) - a receivable which is not considered collectible is charged directly to the income statement.
2. Allowance method (GAAP) - an estimate is made at the end of each fiscal year of the amount of bad debt. This is then accumulated in a provision which is then used to reduce specific receivable accounts as and when necessary.

Because of the matching principle of accounting, revenues and expenses should be recorded in the period in which they are incurred. When a sale is made on account, revenue is recorded along with account receivable. Because there is an inherent risk that clients might default on payment, accounts receivable have to be recorded at net realizable value. The portion of the account receivable that is estimated to be not collectible is set aside in a contra-asset account called Allowance for doubtful Accounts. At the end of each accounting cycle, adjusting entries are made to charge uncollectible receivable as expense. The actual amount of uncollectible receivable is written off as an expense from Allowance for doubtful accounts.

Taxability

Some types of bad debts expense, whether business or nonbusiness related, are considered deductible. Section 166 of the Internal Revenue Code provides the qualifications which must be met in order to meet deductibility status.^[4]

Criteria for deduction

To be considered as deductible, debts:

• must be a bona fide debt, and
• worthless within the taxable year.

A debt is defined as a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a determinable sum of money. The debt in question must also be considered worthless. This distinction is further broken down into the level of collectibles. One must determine whether the qualifying debt is completely or partially worthless. A partially worthless status means a portion of the debt may be recovered in future periods. Numerous factors are taken into consideration including the debtor’s insolvency status, health conditions, credit standing, etc.^[5]

Section 166

Section 166 does limit the amount of deduction allowed. There must be an amount of tax capital, or basis, in question to be recovered. In other words, is there an adjusted basis for determining a gain or loss for the debt in question.

An additional factor in applying the criteria is the classification of the debt (nonbusiness or business). A business bad debt is defined as a debt created or acquired in connection with a trade or business of the taxpayer. Whereas, a nonbusiness debt is defined as a debt that is not created or acquired in connection with a trade or business of the taxpayer. The classification is quite significant in terms of the deductibility. A nonbusiness bad debt must be completely worthless in order to be deducted. However, a business bad debt is deductible whether it is partially or completely worthless.

Mortgage Bad Debt

Mortgages which may become noncollectable can be written off as a bad debt as well. However, they fall under a slightly different set of rules. As stated above, they can only be written off against tax capital, or income, but they are limited to a deduction of $3,000 per year. Any loss above that can be carried over to following years at the same amount. Thus a $60,000 mortgage bad debt will take 20 years to write off^[6]. Most owners of junior (2nd, 3rd, etc.) fall into this when the 1st mortgage forecloses with no equity remaining to pay on the junior liens.

There is one option available for mortgages not available for business debt - donation. The difference is that a valuation of $10,000 can be taken without an appraisal. An appraisal may be able to increase the value to more and must be based on other similar mortgages that actually sold, but generally is less than the face value. The real difference is that as a donation the amount of deduction is limited to up to 50% of Adjusted Gross Income per year with carryovers taken over the next 5 years

^[7]. This is because the deduction is now classified as a donation instead of a bad debt write off and uses Schedule A instead of Schedule D

^[6]. This can significantly increase current year's tax reductions compared to the simple write off. The caveat is that it must be completed PRIOR to the date of final foreclosure and loss. The process is simple, but finding a charity to cooperate is difficult since there will be no cash value as soon as the 1st mortgage forecloses.

References

1. ^ http://www.apm.com.au/osbuyers/glossary.htm
2. ^ http://www.allbusiness.co
3. ^ http://financial-dictionary.thefreedictionary.com/Bad+Debt
4. ^ TaxAlmanac - Internal Revenue Code:Sec. 166. Bad debts
5. ^ Tax Topics - Topic 453 Bad Debt Deduction
6. ^ ^{a b} Form 1040, IRS Instructions for Schedule A (Form 1040)
7. ^ Pub.526, Publication 526 Charitable Contributions

External links

• Bad Debts
• NYSSCPA's glossary of accounting terms