Bad debt

A bad debt is an amount owed by a creditor that is unlikely to be paid and not willing to take action because of various reasons, for example due to a company going into liquidation or insolvency.[1] There are various technical definitions of what constitutes a bad debt, depending on accounting conventions, regulatory treatment and the institution provisioning. In the USA, bank loans with more than ninety days' arrears become "problem loans".[2] Accounting sources advise that the full amount of a bad debt be written off to the profit and loss account or a provision for bad debts as soon as it is foreseen.[1]

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, the condition of item 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 are 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 a bad debt reserve, this is a contra account listed within the current asset section of the balance sheet. The doubtful debt reserve holds 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 an allowance for bad debts. Once a doubtful debt becomes uncollectable, the amount will be written off.

Accounting practice in different countries

United States

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

Gross accounts receivable

$100,000

Less: Allowance for bad debts

$5,000

Net receivables

$95,000

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, whether business or non-business-related, are considered tax deductible. Section 166 of the Internal Revenue Code provides the requirements for which a bad debt to be deducted.[3]

Criteria for deduction

To be considered deductible, the debt must be:

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.[4]

Section 166

Section 166 limits the amount of the deduction. 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 (non-business 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 non-business 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 non-business 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 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.[5] 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

.[6] 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

.[5] 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.

Problem loan

In the USA, bank loans with more than ninety days' arrears become "problem loans".

References

  1. 1 2 "Bad debt": Oxford Dictionary of Accounting, 4th ed., ISBN 9780199563050
  2. ↑ "Bad debt": Oxford Handbook of International Financial Terms,ISBN 9780198294818
  3. ↑ TaxAlmanac - Internal Revenue Code:Sec. 166. Bad debts
  4. ↑ Tax Topics - Topic 453 Bad Debt Deduction
  5. 1 2 Form 1040, IRS Instructions for Schedule A (Form 1040)
  6. ↑ Pub.526, Publication 526 Charitable Contributions

External links

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