What Is Bad Debt And How To Calculate It
Bad debt is a natural and common thing in the business world. It’s a risk that can cause a decrease in the company’s profitability. From the name alone, you might have guessed that it is a type of debt that is defective and is a type of debt that is less recommended. However, what is it and how to calculate it? See the explanation below.
What is Bad Debt?
In general, debt is a method provided by the company as one of the payment flexibility strategies. Over time, some debtors may experience problems that result in bad debt. So, a bad debt is debt whose acceptance is doubtful due to business failure, or the debtor doesn’t pay them on purpose.
This type of debt becomes uncollectible because the debtor goes bankrupt, dies, or other causes make it impossible to collect their debts. In addition, profits owned by the company will occur if the company or debtors don’t receive any bad debts, or in this case, they don’t pay off their loan. Thus, the bad debt should become a burden and eventually reduce net profits.
How to Calculate Bad Debt?
Recording any bad debts will help maintain the company’s financial balances, especially debt balance, cash flow, or net income. When there are no signs from debtors to make payments for their debts within a period of more than 90 days, then it’s time for the company to record it by doing calculations.
To calculate bad debt, it’s usually done in two ways, including:
1. Direct Write Off Method
If a company experiences many bad debts, they’ll write them off on a case-by-case basis, when for sure debtors either can’t or aren’t willing to pay. A company would simply record this type of debt’s expense transactions under the company’s ledger at the value of these debts.
This calculation method can only be used for small nominal amounts. The way to do this is to directly write off to the debtor’s account. Thus, the bad debt expense doesn’t become a loss for the company and reduces profits.
2. Allowance Method
For large nominal amounts, the allowance method of calculating uncollectible accounts is more preferable. Mostly, if a company does a lot of business on credit, this is recommended. This method involves establishing an allowance for bad debts, which is basically a collection of money on a company’s ledger to help pay off all of the bad debts that incur.
The main components of this method include:
- An estimation of the uncollectible accounts debts.
- To charge bad debt expense and a credit allowance for bad debts.
- Write off the bad debts account in the allowance accounts and credit an appropriate debtor’s account.
Final Thoughts
Now you know bad debt is intolerable, especially when offering sales on credit. Companies must understand what it is and how to calculate it, so that profits and other financial conditions are not disrupted. To help calculate and to record the debtor’s debt, companies can do it in two ways, namely write off and allowance methods.
