What Are Bad Debts? (And How To Deal With Them)

When you hear the term ‘debt’, your first instinct will be that it’s not a great thing. Which is why the term ‘bad debt’ can be a bit confusing – after all, isn’t all debt bad? You might think the answer is yes, but really, it’s ‘not really’. Debt is a fundamental part of doing business, and in some situations debt can be a good thing. For example, if you’ve got receivables that will be repaid at an agreed time with interest on top, then you’re dealing with good debt. But if it’s not possible to collect on those receivables, then you’ve got a bad debt on your hands, and your books. And what do you do then?

What Is A Bad Debt?

If we’re going by the technical definition:

‘A bad debt is a monetary amount owed to a creditor that is unlikely to be paid, and for which the creditor is not willing to take action to collect for various reasons.’

In plain English, a bad debt is when you’ve extended credit to a customer, but it’s no longer possible for them to repay it, or for you to collect on that debt. It’s also known as an irrecoverable receivable. Unfortunately, bad debts are a very real possibility for any business that extends credit to its customers, so it’s important to understand what they are, what the risks can be, and have a plan for handling them if a bad debt ever comes across your books.

Why Do Bad Debts Happen?

Ultimately, business finance is a fairly delicate and complex thing, and there’s no ‘one size fits all’ reason for a debt going bad. Bad debts can happen for all sorts of reasons, but it’s usually because the debtor doesn’t physically have the funds to pay the debt. Other common reasons include liquidation or insolvency. In some cases, you might have just been unlucky and extended credit to an unsuitable customer. If this is the case, you can be proactive by tightening up your credit control policies and improving your pre-credit checks on new customers. The final reason behind bad debts is less common, but they can be the result of fraud. In this situation, your business has been deliberately targeted by criminals and there is no way to recover the money you are owed. But in most cases, it all comes down to one thing – the customer is simply incapable of paying your bill.

Is There Anything I Can Do?

Unfortunately, when a debt gets to this stage, there aren’t a lot of things you can do. If the debt is the result of insolvency, then you will be included in the list of debtors and may receive a payment later down the line, when assets have been liquidated and debtors are being paid. But for the most part, you just have to take the hit and move on.

But you also don’t want that debt sitting in the ‘outstanding’ section of your accounting software or your end of year accounts either, so you need to record it properly. There are 2 main ways you can do this:

Bad Debt Write-Off: Best for if you have a specific and recognisable bad debt on your accounts. In the bad debt write-off method, you’ll debit the bad debt expense for the amount of the write off, and credit the accounts receivable asset account for the same amount.

Bad Debt Provision: Better for multiple bad debts, or when you’re unsure of your bad debt total. This method requires you to estimate the amount of bad debt you’ll need to write off in any given period. Essentially, you’ll need to charge an estimated amount of accounts receivable to bad debt expense, before debiting the bad debt expense for the estimated amount of the write-off. Finally, you’ll credit the same amount to the bad debt provision contra account.

Ultimately, the best thing you can do about bad debts is to put processes and policies in place to prevent it happening in the first place. At Debtcol, we can help you understand the root causes behind bad debts, and protect your business from losing money to them in the future. From running credits checks to forensic accounting, business analysis and proactive debt collection, our  experts are here to help you avoid bad debts, for good. To find out more, just get in touch with one of the team today.