Bad Debt

Bad debt is the portion of a company's receivables that are uncollectible. Companies account for bad debt either by the direct method or the allowance method. Under the direct method, the company reduces accounts receivable when a specific invoice is deemed uncollectible. While this method may seem logical, it is only allowed when total bad debt is small and immaterial. Under the allowance method, the company estimates the portion of accounts receivable that will be uncollectible and periodically records charges for bad debt expense. The allowance method is preferred because (a) it recognizes that bad debt is a normal, continually recurring cost of doing business, and (b) under the matching principle, the cost of bad debt more closely corresponds to reported revenue in the accounting period. A significant rise in the bad debt to accounts receivable and bad debt to sales ratios indicate greater risk and a deterioration in the quality of the company's revenues. On the other hand, no or minuscule bad debt may indicate that the firm is too conservative in extending credit.

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