Bad debt for a Lender is an outstanding balance that cannot be recovered due to a borrower defaulting on the loan. In contrast, good debt is when a financial institution expects to make a profit from loans and interest charges.
The following are examples of business bad debts:
- Loans to customers, suppliers, distributors, etc.
- Credit sales to customers.
- Business loan guarantees.
Unfortunately, borrowers may experience financial difficulties during the repayment period. For example, a borrower may take out a loan for car parts and then get laid off unexpectedly, resulting in bankruptcy. When a borrower fails to meet the financial obligations of their loan agreement, the lender cannot expect the recovery of the remaining unpaid debt.
There is always a possibility that a financial institution that provides loans will lose out on lent money. Due to the potential risk of business bad debt, a lender must have a recovery plan in case a borrower experiences unforeseen issues with debt repayment.
How to Record Bad Debt Expense?
A financial institution can record bad debt through a bad debt write-off or a bad debt provision. However, the way lenders record bad debt expenses depends on the country they work in. For example, the Generally Accepted Accounting Principles (GAAP) are only used in the United States. If a financial institution uses GAAP for accounting, it must use the bad debt provision method.
But before learning how lenders record bad debts, knowing what a “contra asset” is is critical. A contra asset is an asset account with a zero or a credit (negative) balance. Allowance for doubtful accounts (ADA) is a type of contra-asset account that creates an allowance for high-risk customers who may not repay a loan, purchased goods, or a service.
Bad Debt Write-Off Method
Bad Debt write-offs are used when lending companies or businesses have a specific bad debt on their account. This calculation method is best for companies that do not have a lot of bad debts and are able to handle them on a case-by-case basis. A write-off means the company is acknowledging the financial loss. In order to use the write-off method, a company must add the bad debt amount to its bad debt expense account.
According to the Internal Revenue Service (IRS), companies should only write off a debt when there is no chance of a customer repaying the debt owed. Before writing off a debt, the business should take reasonable steps to collect the debt. For example, contacting the customer by phone or email about repayment.
Bad Debt Provision Method
The bad credit provision method is also known as the allowance method or provision for doubtful debts. Professional accountants typically prefer the allowance method over the direct write-off method if there is a risk of a lot of bad debt.
To use the bad provision method, a business must estimate the number of accounts receivable that will not be paid back by customers ahead of time. Essentially, the allowance method helps a company establish a pool of money in its ledger, which is also known as:
- An allowance for bad debts.
- A bad debt reserve.
- An allowance for doubtful accounts.
After estimating the bad debt amount, the business will charge it to their bad debt expense in order to “pay.” Recording the allowance for doubtful accounts while conducting a sale or loan offer helps improve the accuracy of financial reports. But suppose the bad debt exceeds the original estimate. In that case, the company must record the bad debt expense on its income statement.
There are two main ways to estimate an allowance for bad debts: the percentage of sales method and the accounts receivable aging method.
Percentage of Sales Method
The percentage of sales method helps a business make financial predictions based on previous and current sales data. The results of this data mining method can help the company develop a monetary plan and make adjustments that can benefit their future earnings. However, this forecasting tool is only helpful for short-term financial predictions.
Accounts Receivable Aging Method
The accounts receivable aging method is also known as the percentage of receivables method. While similar to the percentage of sales method, this method is typically considered more effective and reliable because it helps a business precisely understand how much money can be lost. For example, a company can use the accounts receivable aging method to look at percentages of bad debt expenses (BDE) over smaller time frames (weeks or months).
Bad Debt vs. Good Debt for a Borrower
While all forms of debt may be considered bad, there is a distinct difference between good and bad debt for borrowers. Knowing the difference can help you improve your personal finance and make better borrowing decisions.
A bad debt is an unrecoverable loss for lenders, but it means an entirely different thing for borrowers. A borrower has bad debt when they borrow money to purchase an item that will not increase in value or earn them any money. For example, a pawn shop loan is a type of bad debt because you are paying to borrow money and gaining nothing in return.
Good debt helps borrowers acquire a valuable asset that can increase their wealth or help them earn additional income. Although the borrower has additional debt in their name, they are working towards a financial goal that can benefit their future.
These are some examples of good debt:
- Mortgage — A mortgage loan is a form of good debt because you gain real estate property. Paying off the mortgage over time helps you earn equity, which you can use to borrow money or sell at a profit.
- Student Loan — A student loan is considered good debt because the borrower gains a degree, which they can use to earn additional income. Although you are spending money on yourself, you can expect a monetary return on this type of investment.
- Auto Loan — Borrowers can use auto loans to buy new or used vehicles. A vehicle is a valuable asset that helps you gain equity. And if you run into financial trouble, you could sell it for a significant amount of emergency funding.
How Much Debt Is Too Much?
If you have Outstanding debt in your name, you may wonder if you have more or less than the average consumer. Is it possible for someone to have too much debt? The answer is yes.
There is no ideal amount of debt a consumer should have because the amount of debt a person can handle depends on their income, monthly expenses, and other financial factors. But if you struggle to keep up with your loan payments, your debt-to-income (DTI) ratio is too high. Consumers with a high DTI may have a bad credit score and thus have difficulty qualifying for loans with reasonable repayment terms.
Typically, financial experts advise consumers to avoid having a DTI higher than 36%. Suppose your DTI is higher than 36%. In that case, you may limit your financial opportunities and negatively affect your credit rating.
In order to calculate your current DTI ratio, follow these three steps:
- Step 1 — Add up all your monthly bills (auto payments, rent, credit card payments, etc.)
- Step 2 — Divide the total by your gross monthly income (income before taxes).
- Step 3 — Get your total DTI in the form of a percentage!
How to Quickly Pay Off Bad Debt
Paying off any debt you have can help you save money on interest charges and improve your credit score. Learn how to quickly pay off bad debt below to regain your financial freedom!
Consolidate Your Debt
Debt consolidation is the process of merging multiple debts into one account to save money and simplify your finances. Consumers can consolidate using a personal loan or a balance transfer credit card. Suppose you have multiple debts that each have a different interest rate and repayment schedule. You could use a personal loan to get a lower interest rate and monthly payment amount!
Use the Avalanche Method
The Debt avalanche method is a debt repayment method that helps borrowers save money on interest charges. You start by making dedicated payments to the debt that has the highest rate of interest. Until the high-rate debt is repaid in full, you must make minimum payments on all other debts. Once that debt is repaid, you can move on to the second highest-rate loan.
Use the Snowball Method
The snowball method is similar to the avalanche method, but it focuses on the smallest debts first. Paying off your debts from smallest to largest can keep you motivated toward complete debt repayment. While you may not save as much on interest fees, you can start to reduce the number of debts you have much faster.
Reduce Your Monthly Expenses
The best way to pay off your total debt quickly is to increase your income. One simple way to increase your monthly spending budget is to reduce the cost of your monthly expenses. Suppose you stop paying for a gym membership ($80), Netflix ($19.99), Spotify ($9.99), and DashPass ($9.99). Within one month, you will have saved $119.97! You can use that extra income to pay down your debts faster!
References:
What is bad debt?│GoCardless
Allowance for Doubtful Accounts and Bad Debt Expenses│Cornell University
Percentage of sales method: What it is and how to calculate it│Zendesk