What is bad debt and why is it so bad?
Debt is a fundamental part of modern trading. But not all debt is equal; there is good debt and bad debt. Good debt will be repaid within the agreed timeframe, potentially with interest, depending on the agreement. Bad debt, on the other hand, is money lost. This type of debt is not collectible and needs to be written off. Before it reaches this stage, however, there are useful steps for dealing with late payment.
How debt transitions into bad debt
Bad debt emerges in a number of scenarios. It could result from lending money to an unsuitable customer – usually because the customer due diligence process wasn’t robust enough. Or it could stem from fraud, where criminals have carefully and deliberately circumvented due diligence processes. Alternatively, as often happens in the fast paced nature of modern business, the customer’s circumstances may have changed suddenly leading to insolvency and bankruptcy. This was particularly prevalent in the wake of the global financial crisis.
In certain cases, bad debt may be collectible, but the cost of pursuing the debt outweighs the value of recouping it.
Allowing for bad debt
The majority of companies make sales on credit because this enables them to sell more. This debt owed to them is called ‘receivables’ and is treated as an asset. However, it is typical accounting practice for companies to estimate what proportion of sales they expect to lose to bad debt. This is called the allowance or provision for bad debt and is a proactive measure to stabilise lending through bad debt provision.
There is, however, a stage before bad debt, which is doubtful debt. This refers to debt that has been identified as problematic and so the business anticipates that it may become bad debt in the future. This awareness may stem from a dispute with the customer or knowledge that the customer is having financial difficulties.
Accounting practices for bad debt
There are two accounting methods to manage bad debt. The first involves providing for bad debt in advance, as described above, to mitigate the financial impact before it happens. This approach is called the allowance method and businesses usually create a doubtful debt reserve of funds.
The reserve fund acts as a contra, offsetting the business’s assets to ensure the balance sheet remains as accurate as possible throughout the financial year. By providing for and ringfencing bad debt, companies are better able to manage their own finances and prevent supply chain contamination.
The second accounting method is more reactive: once doubtful debt becomes bad debt, it is charged directly to the income statement at that stage. This is known as the direct write-off method. Although it is, in some ways, more accurate as it doesn’t involve estimating the volume of debt, it means businesses are less proactive in mitigating debt in advance.
Tax deductible bad debt
Although bad debt can be highly dangerous for businesses, it is sometimes tax deductible. The debt does, however, have to be recorded and written off in order to be tax deductible and reasonable attempts to recover the debt must have been made. For debt of a considerable amount, legal action would need to be taken before the debt is declared bad.
It can also be possible to claim a deduction on debt that has been partially written off. However, debts owed by related parties, for example family members, business partners or shareholders, are not tax deductible.
The impact of bad debt
Since the financial crisis, bad debt has rippled around the globe, forcing business, banks and governments to enact debt write offs. Indeed, in 2015, UK banks and building societies wrote off £3.175 billion of loans to individuals, according to The Money Charity. In the last quarter of 2015, they wrote off £1,046 million, which equates to £11.4 million of debt written off each day .
The Eurozone crisis, which followed on from the global financial crisis, saw dramatic debt relief measures implemented around the Eurozone in order to save the single currency and prevent national economies from crumbling. In Greece alone, government debt reached €320 billion euros at the end of 2014, of which €195 billion is bailout money , with many arguing that some of this debt should be written off.
Although the Eurozone crisis may have cooled down since the height of its panic, global concerns about rising bad debt and contamination are now shifting further east. Bad debts in china have risen for 18 consecutive quarters, following an economic slowdown and the fallout of government stimulus .
It remains to be seen what further effect this will have on the financial markets. But, as is clear from recent history, the impact of bad debt spreads far beyond individuals and businesses – contaminating banks, governments and global economies.