Bad Debt
Accounts receivable that are uncollectible and must be written off as a loss.
Definition
Bad debt refers to money owed to your business that you cannot collect—typically from customers who can't or won't pay their invoices. When an account is deemed uncollectible, it's written off as a bad debt expense, removing it from accounts receivable and recording it as a loss.
Businesses typically establish bad debt reserves (allowance for doubtful accounts) based on historical collection rates. For example, if you historically fail to collect 2% of invoiced amounts, you might reserve 2% of AR as an allowance. This accounting practice more accurately reflects the true value of your receivables.
Why It Matters
Bad debt directly impacts profitability—it's revenue you earned but will never receive. Managing bad debt starts with prevention: credit checks, appropriate payment terms, and proactive collection. Once an invoice becomes significantly past due, collection rates drop sharply.
Tracking your bad debt ratio (bad debts ÷ total credit sales) helps you evaluate your credit policies. A rising ratio might indicate loosening credit standards, economic changes affecting customers, or collection process problems. Most businesses aim for bad debt ratios under 2-3% of credit sales.
Examples
- 1
A B2B company writes off a $15,000 invoice after 180 days of unsuccessful collection attempts and determining the customer is insolvent.
- 2
A small business maintains a 3% bad debt reserve based on their historical 3% write-off rate.
- 3
A consultant reduces bad debt by requiring 50% deposits on all new projects over $5,000.
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