Under generally accepted accounting principles, or GAAP, in the United States, bad debt is a portion of money owed a business that it expects will not be paid. Bad debt results in an expense – thus a loss to the business. Bad debts in accounting may appear on the financial statements under several similar names -- "uncollectible" or "doubtful" accounts are two common terms -- and it may also appear on multiple places on the financial statements.
A company may record bad debt on a balance sheet as an "allowance for doubtful accounts." On the income statement, it may be recorded as an expensive or as an "extraordinary item."
Bad Debts in Accounting
Bad debts occur when a company is unable to recover a debt it is owed. For a bad debt to be recorded, that debt owed the company must be recorded on the company's financial statements. Although, for most companies, bad debts are most commonly associated with accounts receivable from the sale of goods and services, they may relate to any debts owed a company, including loans and deposits. Bad debt is an estimate the company's management calculates.
Bad Debt on Balance Sheet
Bad debts are often first recorded on a company's balance sheet. When a company thinks it's unlikely to collect money owed, it will establish an "allowance for doubtful accounts" that will be used to offset, or reduce, the amount of debt reported as an asset on the company's financial statements. An allowance for doubtful accounts is only used when the collectibility of the debt is in question. When the debt is clearly not collectible, the entire asset will be removed from the balance sheet.
Bad Debt on Income Statement
Whenever a bad debt is recorded, it is also reported on the company's income statement, or statement of earnings, for the period in which it is recorded. The bad debt is an expense and reduces the amount of a company's net income or increases the amount of a company's net loss. Bad debt is typically included in the calculation of a company's ordinary income, although in very rare cases of significant one-time loss, bad debt expense is reported on the income statement as an "extraordinary item."
How Companies Manage Earnings
Because bad debt expense is typically an estimate, a company's management can manipulate the estimate to manage a company's earnings. Companies wishing to show steady, consistent earnings may be tempted to manipulate the amount of bad debt expense either up or down over consecutive periods to "smooth" the earnings and avoid significant earnings volatility from period to period. Auditors of financial statements will typically examine the bad debt estimations to ensure this does not occur.
Tax Treatment of Bad Debt
Since bad debt is a deductible amount for income tax purposes, there is additional incentive for management to overestimate its bad debt. However, in the United States, it is typically more difficult to deduct bad debt for income tax purposes than it is for financial statement reporting purposes. The Internal Revenue Service has numerous requirements and tests to determine which bad debts may be deductible.