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What are Bad Debts? Reasons for Bad Debt

IndianMoney.com Research Team | Posted On Tuesday, October 22,2019, 04:05 PM

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What are Bad Debts? Reasons for Bad Debt

 

 

 What are Bad Debts?

Bad debt is an amount that is now irrecoverable from the entity that was about to pay it. There are various reasons why debtors cannot repay their debts, they either go bankrupt or have financial problems, trade dispute or fraud. Bad debts are allowed for a tax deduction. If an entity realises that it is unlikely to recover that debt from the debtor, it must write off the debt from its books.

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 Reasons for Bad Debt:

  • Bad debts are incurred when an individual has poor financial management and he is not able to pay his debt on time.
  • In case the debtor is unwilling to pay or is no longer capable of paying the debt. This is one of the key reasons most debts become bad debts.
  • When the creditors are not able to collect the debts due to some other reasons.
  • Debts convert into bad debts when some dispute arises regarding price, quality, delivery or products.

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Provision for Bad Debt:

Provision for bad debt can be defined as the percentage of total doubtful debt that must be written off during the next year. Doubtful debt often ends up as a loss to the company and these kinds of debts needs mentioned in the profit and loss account in the form of provision.

Debts can be classified into various categories which are as follows:

  • Bad Debts: Bad debts are the debts that remain unpaid. In short, it means irrecoverable or uncollectable debts.
  • Doubtful Debts: These debts the ones that will be receivable or the ones that cannot be ascertainable at the date of preparing the financial statement. In simple words, these are the debts that are doubtful in its realization.
  • Good Debts: These debts are the debts that do not have any doubt about its realization. These debts have a minimum possibility of turning into bad debts.

These debts carry uncertainty about their repayment by the debtor. When the creditor realises that the debtor is not willing to that part of the debt, he must record it in this account. Later if the amount is settled, he must deduct the amount from the provisions account. If the creditor doesn’t receive the amount he must consider it as bad debt and must write off the same. These records give an accurate estimate of the receivables. Thus the creditor can avoid current assets from being overstated.

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 Bad Debts Entry:

All debtors are not able to repay their debts due to several reasons. Most often debtors are unwilling or go bankrupt and so the debts that are not settled convert into bad debt. The bad debts are either partially or fully recovered after they are written off. The journal entry for bad debts is a method to make an official entry of these accounts in the income statement of the company to adjust against the current period’s income.

There are two ways to account for bad debt. The direct write off method and the journal entry method.

Bad Debts That are Written Off:

Bad debts are thought to be irrecoverable. Since these are the debts that are not collectable they must be written off as an expense.

Bad debts are written off to calculate the value of the current assets more accurately. Write off means adjusting your accounts book to represent the actual amount in your current account. To write off bad debt, you need to remove it from the amount in your accounts book.

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Bad Debts Recovered:

Bad bets can be recovered after they were written off in the previous year. The bad debt recovery is the process of recovery of these losses either fully or partially. It is the income of the entity and hence it is recorded on the credit side of the income statement. In case the company doesn’t recognise this as income they may exclude it from the financial statements. The amount that was written off in the previous year is the amount that needs to be recovered.

Sometimes debts that are written off as bad debts are subsequently settled by the debtor in full or partly. In such cases, it is important to cancel the effect of the bad debt expenses previously recorded.

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