what is bad debt 
bad debt is an amount of money that a creditor must write off if a borrower defaults on the loans if a creditor has a bad debt on the books it becomes uncollectible and is recorded as a charge off bad debt is a contingency that must be accounted for by all businesses that extend credit to customers as there is always a risk that payment won t be collected these entities can estimate how much of their receivables may become uncollectible by using either the accounts receivable ar aging method or the percentage of sales method investopedia dennis madambaunderstanding bad debtbad debt is any credit advanced by any lender to a debtor that shows no promise of ever being collected either partially or in full any lender can have bad debt on their books whether that s a bank or other financial institution a supplier or a vendor bad debts end up as such because the debtor can t or refuses to pay because of bankruptcy financial difficulty or negligence these entities may exhaust every possible avenue to collect on bad debts before deeming them uncollectible including collection activity and legal action businesses must account for bad debt expenses using one of two methods the first is the direct write off method which involves writing off accounts when they are identified as uncollectible while this method records the precise figure for accounts determined to be uncollectible it fails to adhere to the matching principle used in accrual accounting and generally accepted accounting principles gaap the second is the matching principle which requires that expenses be matched to related revenues in the same accounting period they are generated bad debt expense must be estimated using the allowance method in the same period and appears on the income statement under the sales and general administrative expense section since a company can t predict which accounts will end up in default it establishes an amount based on an anticipated figure in this case historical experience helps estimate the percentage of money expected to become bad debt the direct write off method is used in the united states for income tax purposes special considerationsthe internal revenue service irs allows businesses to write off bad debt on schedule c of tax form 1040 if they previously reported it as income bad debt may include loans to clients and suppliers credit sales to customers and business loan guarantees however deductible bad debt does not typically include unpaid rents salaries or fees 1for example a food distributor that delivers a shipment to a restaurant on credit in december will record the sale as income on its tax return for that year but if the restaurant goes out of business in january and does not pay the invoice the food distributor can write off the unpaid bill as a bad debt on its tax return in the following year individuals are also able to deduct a bad debt from their taxable income if they previously included the amount in their income or loaned out cash and can prove that they intended to make a loan at the time of the transaction and not a gift the irs classifies non business bad debt as short term capital losses 1the term bad debt can also be used to describe debts that are taken to pay for goods that don t appreciate in other words bad debt is a form of borrowing that doesn t help your bottom line in this sense bad debt is in contrast to good debt which an individual or company takes out to help generate income or increase their overall net worth 