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Bad debt expenses are any type of expenses a company incurs as it attempts to collect on receivables that are significantly past due. Along with including the amount of the bad debt itself, the figure is also likely to include expenses related to the collections effort. A bad debt expense may involve time and resources spent sending past due notices, applying late charges to the outstanding balance, and any type of fees involved with attempts to collect the bad debt through a court system.
Many businesses recognize the potential for a portion of the receivables to remain uncollected. For this reason, it is not unusual for a business to include a section or a line item within the accounting records that is known as an allowance for doubtful accounts. Often, this balance is calculated as a percentage of the total outstanding receivables for the period cited. Some businesses place specific customer accounts into this category, based on slow payment histories, or news in the business community of impending financial problems for the customer. Allowing for some degree of bad debt expense helps to minimize the potential for the business to possibly find itself in a cash flow crunch, and be unable to meet its own debt obligations in a timely manner.
Tracking bad debt expense is important for several reasons. First, the process allows the business to identify what portion of its resources are going to collections efforts. This includes the time of personnel, administrative costs, and the costs associated with outsourcing collections efforts. When a company finds that it is spending an inordinate amount of money attempting to collect on a bad debt, it is obvious that changes must be made in the procedures for qualifying the credit worthiness of new clients, as well as periodically evaluating the credit status of existing clientele.
Another reason to track bad debt expense has to do with tax breaks. In some countries, federal tax agencies allow businesses to claim a deduction on any bad debt that is incurred within a specific tax period. This tax break is usually in the form of a percentage of the bad debt, or a maximum amount allowed, whichever is lesser. Depending on the circumstances, the figure may be enough to help reduce the overall tax burden for the company, a measure that helps to offset more of the loss that the company incurred as a result of the bad debt.
Companies are generally slow to declare delinquent balances on customer accounts to be bad debts. The goal is to work with customers having cash flow issues and make payment arrangements that ultimately result in settling the accounts in full. When all reasonable efforts to manage this process have failed, the original balance, any penalties and interest applied to that balance, and any identifiable expenses related to the collection efforts can all be counted as bad debt expense.
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