One of the factors that a business must account for in estimating and calculating their earnings is the part of their collectibles that won't be paid. This number for a company is called bad debt expense. They must estimate an amount that won't be collected, for every dollar that a company is owed.
This could be for a wide variety of reasons. In many businesses, their customers are other businesses. A supplier might sell an article that they manufacture to a retailer, but if that retailer goes out of business before paying off their obligations, their debt to the vendor may never be paid. If your customer is an individual consumer, elements such as loss of employment, extended illness, or personal bankruptcy might make the debt impossible to collect.
I just needed to talk about it
Companies account for bad debt by estimating the amount of their outstanding receivables that will be bad in each accounting period. Bad debt is considered an expense when it is a question of generally accepted accounting principles, thus reducing net income. There are consequences for both business and consumers when it comes to bad debt expense. There are steps that a company can take to reduce that amount of debt that goes uncollected.
Companies have the entitlement to dictate the terms and conditions of the credit they extend. Being flexible in giving consumers a longer period of time to settle their account balance may be nice from a customer relations standpoint. However, it may give rise to headaches for the accounting department as cash flows stall and bad debt piles up. Tightening credit terms so that debts must be given in a shorter amount of time can help a company determine which of their receivables may go uncollected.
It also could scare away consumers that are not confident in their capacity to pay on time. These are consumers that you probably do not want owing you money in the former place. A cost of bad debt expense for consumers is that even good borrowers might be required to adhere to strict credit terms, owing to the few bad borrowers that fail to pay.
Take a home mortgage for example. In most cases this is considered good debt. This is because over time the utility of a home appreciates. A home that is worth two hundred thousand today will likely be worth more than that in twenty years, even through the ups and downs of a fickle economy. This is called good debt because it is money owed for something people need and as the value is liable to increase.
So what is bad debt? Consider using a credit card to eat out twice a week. This is bad debt because the items being purchased are being consumed and can thus never appreciate in value. Using department store credit cards to buy clothes is generally thought of as bad. If the item being purchased won't be around in just a few years to grow in value, it is normally considered to become a debt that is bad.
One of the challenges of accounting for bad debt expense is knowing when an obligation is truly bad debt instead of just late or partial payments. A company needs to clearly define the cases in which bad debt will be written off the books and prepare a plan for trying to collect on the debts that remain in place on the books. A company also has to decide how they'll qualify borrowers.
It's possible to sell these receivables to outside companies who'll assume the likelihood of the debts going uncollected, for debts that seem to be bad. This business is known as factoring. Items done by bundling a portion of accounts receivable and selling them at a discount to a company that will seek to collect them all.
Bad debt expense is an unfortunate cost of doing business. However, taking steps to keep exposure low can increase profitability for a company.
This could be for a wide variety of reasons. In many businesses, their customers are other businesses. A supplier might sell an article that they manufacture to a retailer, but if that retailer goes out of business before paying off their obligations, their debt to the vendor may never be paid. If your customer is an individual consumer, elements such as loss of employment, extended illness, or personal bankruptcy might make the debt impossible to collect.
I just needed to talk about it
Companies account for bad debt by estimating the amount of their outstanding receivables that will be bad in each accounting period. Bad debt is considered an expense when it is a question of generally accepted accounting principles, thus reducing net income. There are consequences for both business and consumers when it comes to bad debt expense. There are steps that a company can take to reduce that amount of debt that goes uncollected.
Companies have the entitlement to dictate the terms and conditions of the credit they extend. Being flexible in giving consumers a longer period of time to settle their account balance may be nice from a customer relations standpoint. However, it may give rise to headaches for the accounting department as cash flows stall and bad debt piles up. Tightening credit terms so that debts must be given in a shorter amount of time can help a company determine which of their receivables may go uncollected.
It also could scare away consumers that are not confident in their capacity to pay on time. These are consumers that you probably do not want owing you money in the former place. A cost of bad debt expense for consumers is that even good borrowers might be required to adhere to strict credit terms, owing to the few bad borrowers that fail to pay.
Take a home mortgage for example. In most cases this is considered good debt. This is because over time the utility of a home appreciates. A home that is worth two hundred thousand today will likely be worth more than that in twenty years, even through the ups and downs of a fickle economy. This is called good debt because it is money owed for something people need and as the value is liable to increase.
So what is bad debt? Consider using a credit card to eat out twice a week. This is bad debt because the items being purchased are being consumed and can thus never appreciate in value. Using department store credit cards to buy clothes is generally thought of as bad. If the item being purchased won't be around in just a few years to grow in value, it is normally considered to become a debt that is bad.
One of the challenges of accounting for bad debt expense is knowing when an obligation is truly bad debt instead of just late or partial payments. A company needs to clearly define the cases in which bad debt will be written off the books and prepare a plan for trying to collect on the debts that remain in place on the books. A company also has to decide how they'll qualify borrowers.
It's possible to sell these receivables to outside companies who'll assume the likelihood of the debts going uncollected, for debts that seem to be bad. This business is known as factoring. Items done by bundling a portion of accounts receivable and selling them at a discount to a company that will seek to collect them all.
Bad debt expense is an unfortunate cost of doing business. However, taking steps to keep exposure low can increase profitability for a company.