Accounting and bookkeeping
Bad debt
Bad debt is a monetary amount owed to a business that is no longer recoverable because the customer is unable or unwilling to pay their outstanding invoice.
What is Bad debt?
When you sell goods or services on credit, you expect your customers to pay you on time. Unfortunately, some invoices remain unpaid due to customer bankruptcy, disputes, or financial hardship. When it becomes clear that you will never collect this money, the outstanding balance becomes a bad debt. In accounting, you must recognise this loss so your financial statements accurately reflect your true assets. There are two main ways to record this. A provision for bad debts is an estimate you make in advance based on historical trends, anticipating that a certain percentage of your total receivables will default. A write-off is a specific decision to remove a known, uncollectible invoice from your accounts receivable. By acknowledging bad debt, you prevent your business from paying taxes on phantom profits that you will never actually receive.
(Total Bad Debts / Total Credit Sales) x 100
This ratio shows the percentage of your credit sales that end up as uncollectible losses. A rising percentage indicates you may need stricter credit limits.
How Bad debt works
The lifecycle of a bad debt begins the moment you issue an invoice on credit. As the payment deadline passes, the invoice becomes overdue. You typically follow a standard dunning process, sending reminders and statements of account to encourage payment. If the customer ignores these notices or informs you they cannot pay, you must evaluate the likelihood of recovery. Once you determine the amount is uncollectible, you remove the invoice value from your accounts receivable and record it as a bad debt expense in your general ledger. If you use the allowance method, you first create a provision based on estimated losses, then apply the specific uncollectible amount against that provision. This ensures your profit and loss statement accurately reflects the loss.
- Issue an invoice to a customer with agreed payment terms.
- Monitor accounts receivable and identify invoices that are severely overdue.
- Exhaust all reasonable collection efforts through a structured dunning process.
- Determine that the outstanding balance is permanently uncollectible.
- Record a journal entry to move the amount to bad debt expense.
Worked example
Gulf Traders LLC sells office supplies to local businesses on net-30 terms. In one financial year, they record 200,000 OMR in total credit sales. By the end of the year, three customers have gone out of business, leaving unpaid invoices totalling 4,000 OMR. Gulf Traders determines these invoices are uncollectible and writes them off. To calculate their bad debt ratio, they divide 4,000 by 200,000, which equals 0.02. Multiplying by 100 gives a bad debt ratio of 2 percent. This means Gulf Traders loses two percent of its credit revenue to defaulting customers.
Why it matters for your business
Ignoring bad debt artificially inflates your assets and your taxable income. If you leave uncollectible invoices sitting in your accounts receivable, your balance sheet will look healthier than it actually is. This misleads investors and lenders, and it means you might pay corporate income tax on revenue you never collected. High bad debt levels also severely restrict your working capital, leaving you without the cash needed to pay your own suppliers or staff. Paper & Pen tracks your accounts receivable and posts journal entries to help you manage these write-offs accurately. Monitoring your uncollectible accounts forces you to tighten your credit limits and vet new customers more carefully before offering them payment terms.
See also
Questions
Common questions
Can I claim back the VAT on a bad debt?
What happens if a customer pays after I write off their debt?
Related terms
- Accounts receivable Accounts receivable represents the total amount of money owed to a business by its customers for goods or services that have been delivered but not yet paid for.
- Write-off A write-off is an accounting action that reduces the recorded value of an asset to zero when it loses all its value or a customer fails to pay an outstanding invoice.
- Aging report An aging report is an accounting document that categorises a company's accounts receivable or payable based on the length of time an invoice has been outstanding.
- Dunning Dunning is the systematic process of communicating with customers to ensure the collection of accounts receivable, typically involving a series of increasingly urgent payment reminders for overdue invoices.
- Credit limit A credit limit is the maximum amount of unpaid invoices a business allows a specific customer to accumulate before requiring payment to release further goods or services.
- Accounts payable Accounts payable is the total amount of short-term debt your business owes to suppliers and vendors for goods or services that you have received but have not yet paid for.