Bad debt is a term that is used in accounting. It is the fraction of the accounts receivable that cannot be collected any more. The accounts receivable of a company can be from individuals, businesses and organizations. Because of this, the debt counts as an expense. To truly understand the calculations involved, it may be helpful to take an accounting class.
There are two ways used in accounting for the bad debt. The first one is the Non-GAAP or the direct write off method and the second one is the GAAP or the allowance method.
Here are some of the ways on how you can compute bad debt:
- Direct write off method. For the direct write off method, the uncollectible amounts are deducted from the revenue of the sales. It is charged directly to the income statement. This method is not for financial reports. This is because of the disadvantages that come with using the direct write off method, like unmatched balance with the sales revenue and the supposed accounts receivables are overemphasized.
- Accounting method. For the accounting method, a percentage of the revenue from all the sales is set aside to cover the bad debts in an accounting period. The lack of money or the excess from the estimation is then fixed on the following accounting period.
For the accounting method, the income statement method can be used for the financial debt. The estimate of the accounts receivable depends greatly on the credit sales. The estimation balance in the account is not considered at the end of the accounting period.
The balance sheet method can also be used. In the balance sheet method, the estimation in this method is taken into consideration Because of the estimate, the account can have a debit balance or a credit balance.
Because the bad debt is considered by a company to be an expense, the company loses revenue and this in turn reduces the company’s taxable income. Having a lot of bad debt deprives the business of the cash flow that is needed to keep the business afloat.
Even if there are bad debts, some of them can be deductible from tax. These debt laws can be seen in Section 166 of the IRC or the Internal Revenue Code. The deductibility of the bad debt can either be a personal debt or a business related debt. There must be some qualifications that must be met in order for the bad debt to be deducted from the tax. The first is that the debt must be real and that it does not have value for the current taxable year.
These are the ways on how you can compute the bad debt based on the direct write off method and the accounting method. To make things simple in bookkeeping, you can credit the accounts receivable and debit the value of the bad debt. To know more about the details of bad debt, you can refer to the Internal Revenue Code Section 166 that focuses on bad debt. You can also sign up for individual courses or a two-year degree program in accounting and finance to improve your understanding of how to not only write off bad debt, but manage funds so that these debts will not significantly affect your business.