what is bad debt?

Bad Debts or Doubtful Debts

Bad debts, as the name suggests, can be a very negative mark on your credit history. Bad debts or doubtful debts are that you can no longer clear or pay off. Yes, it sounds scary, but one can provision these debts, and there are ways in which you can get them off your back. Bad debts are usually involved in failed businesses or companies that have gone into liquidation.

Not many debt holders are aware of the available facilities to recover or account for these bad debts. It is essential that people know about these facilities and use them to get rid of the bad debts.

What are Bad Debts?

We call a debt a bad debt when the collectors no longer need it, and the debt holder cannot repay due to bankruptcy or some other financial problem. It is an outstanding debt that you cannot repay. Collectors do not want to receive it anymore and are willing to deduct it. Debt holders can get help from the government as well to write it off.

For the government to reduce bad debts, loans from banking and money lending companies should be incapable of recovering it. Different countries have different accounting practices for bad debts. In the U.S., the income tax act of 1961 states the Allowance method. The allowance or GAAP method is one of the best options to clear bad debts.

One other way is writing it off. By writing it off, we mean that if your company’s debt was not payable in the past accounting year, you could write it off as an expense in your income tax. It is otherwise called the Non-GAAP method.

Allowance for bad debts:

Allowance for bad or doubtful debts is an account that calculates the percentage of receivables that can become uncollectible. Lenders use assistance to clear off the bad debts of their debt holders. It is a fact that you cannot collect all the money you lend to customers. It is where allowance helps a company calculate the percentage of collectibles that have the probability of being uncollectable.

The GAAP method of allowance has the following conditions before it permits you to make an allowance for bad debts:

  • The assessee must have used the loan for a business or profession and in the past accounting year.
  • If the debt is due from a retired partner, then the assessee cannot deduct it as it is a capital loss.
  • An assessment can deduct the loans only he has included in the computation of Income-tax return in the current year or previous years.
  • The assessee must claim a deduction for those debts that have been bad for the past accounting year.
  • The assessee will be eligible for the deduction only if they have written off the debts they need to deduct from the books in the previous financial year.

Under these conditions, the assessee will make an allowance or deduct the bad debts or doubtful debts.

Business Discontinued, Continuing Bad Debts:

In case a debt holder has already discontinued the business before the beginning of the past accounting year, he/she cannot claim a deduction from the company’s profit that he/she is currently continuing. It is by section 36(2) (iii), which states if an assessee has already written off the bad debts in the book of accounts but cannot deduct it by the A.O. because you can still recover the debt. In such a case, the assessee can remove the debt once it becomes irrecoverable.

It is the case for bad debts with discontinued business. You can make an allowance or deduct it only if it becomes uncollectible. If not, you will have it pay it off.

When you recover bad debts:

There are chances for an assessee to encounter such a situation as well. The assessee could have already written off or deducted, or made an allowance for the particular bad debt. But the debt holder can repay it in full, and you, the assessee, have recovered some of the bad debt. In such a case, you will have to write it off as an income in the current financial year when you recover the money in the book of records.

If the debt holder pays only part of the bad debt, then you will have to treat the debt as the standard realization of debt and the rest of the debt as bad debt. If the amount received is more than expected, you must consider the exceeded amount as the current financial year’s income.

Provisions for bad or doubtful debts:

As per the provision for bad and doubtful debts, section 36 allows only banks and financial institutions to deduct bad or doubtful debts. The condition refers to estimating the bad or doubtful debt that an assessee will need to write off in the current financial year.

The deduction and allowance policies of bad and doubtful debts differ from each country. People must be aware of the conditions required to be eligible for a deduction and writing off bad and doubtful debts. Banks and financial companies have provisions, as the bad and doubtful debts amount to money lending companies.

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