Editing Bad debt (section)

==Accounting practices ==

===United States===
In financial [[accounting]] and [[finance]], bad debt is the portion of [[receivable]]s that can no longer be collected, typically from [[accounts receivable]] or [[loan]]s. Bad debt in accounting is considered an expense.

There are two methods to account for bad debt:
# Direct write off method (Non-[[Generally Accepted Accounting Principles (Canada)|GAAP]]): a receivable that is not considered collectible is charged directly to the [[income statement]].<ref>{{Cite web|title=Bad Debt Expense|url=https://corporatefinanceinstitute.com/resources/knowledge/accounting/bad-debt-expense/|access-date=2021-11-16|website=Corporate Finance Institute|language=en-US}}</ref>
# Allowance method (GAAP): an estimate is made at the end of each fiscal year of the amount of bad debt. This is then accumulated in a provision that is then used to reduce specific receivable accounts as and when necessary.<ref>{{Cite web|title=Allowance Method For Uncollectibles|url=https://www.principlesofaccounting.com/chapter-7/approaches-for-uncollectibles/|access-date=2021-11-16|website=principlesofaccounting.com|language=en-US}}</ref>
#*Allowance for bad debts are amounts expected to be uncollected but that are still possible to be collected (when there is no other possibility for collection, they are considered uncollectible accounts). For example, if [[gross receivables]] are [[US$]]100,000 and the amount that is expected to remain uncollected is $5,000, [[net receivables]] will be [[US$]]95,000.

The [[matching principle]] of accounting calls for [[revenue]]s and [[expense]]s to be recorded in the period in which they are incurred. When a sale is made on account, revenue is recorded along with account receivable.<ref>{{Cite web|title=Matching Principle|url=https://corporatefinanceinstitute.com/resources/knowledge/accounting/matching-principle/|access-date=2021-11-16|website=Corporate Finance Institute|language=en-US}}</ref> Because there is an inherent risk that clients might [[default (finance)|default]] on payment, accounts receivable have to be recorded at [[net realizable value]]. The portion of the account receivable that is estimated to be not collectible is set aside in a contra-asset account called "allowance for doubtful accounts". At the end of each [[accounting cycle]], [[adjusting entries]] are made to charge uncollectible receivable as expense.<ref>{{Cite web |title=What Is the Accounting Cycle? Steps and Definition |url=https://www.netsuite.com/portal/resource/articles/accounting/accounting-cycle.shtml |website=Netsuite.com}}</ref> The actual amount of uncollectible receivable is written off as an expense from allowance for doubtful accounts.<ref>{{Cite web|title=Allowance for Doubtful Accounts and Bad Debt Expenses {{!}} Cornell University Division of Financial Affairs|url=https://www.dfa.cornell.edu/accounting/topics/revenueclass/baddebt|access-date=2021-11-16|website=www.dfa.cornell.edu}}</ref>

====Taxability====
Some types of bad debts, whether business or non-business-related, are considered tax deductible. [[Internal Revenue Code section 166|Section 166]] of the [[Internal Revenue Code]] provides the requirements for which a bad debt to be deducted.<ref>{{cite web|url=http://www.taxalmanac.org/index.php/Internal_Revenue_Code:Sec._166._Bad_debts|title=www.taxalmanac.org/index.php/Internal_Revenue_Code:Sec._166._Bad_debts|access-date=6 June 2016}}</ref>

====Section 166====
Section 166 limits the amount of the deduction. There must be an amount of tax capital, or basis, in question to be recovered. In other words, there is an adjusted basis for determining a gain or loss for the debt in question.

An additional factor in applying the criteria is the classification of the debt (non-business of business).<ref>{{Cite web|title=Important FAQ: Section 166|url=http://www.nysscpa.org/news/publications/the-tax-stringer/stringer-article-for-authors/important-faq-section-166|access-date=2021-11-16|website=www.nysscpa.org}}</ref>

====Business bad debts ====
Business bad debts are debts closely related to your business or trade.<ref>{{Cite web |title=File Taxes Online - E-File Federal and State Returns {{!}} 1040.com |url=https://www.1040.com/tax-guide/taxes-for-the-self-employed/deducting-bad-debt/ |access-date=2024-03-22 |website=www.1040.com |language=en}}</ref> They are created or gained through transactions directly or closely related to your business or trade. A loss from a business bad debt occurs once the debt acquired or gained has become wholly or partly worthless.

Bad business debt examples include:

* Credit sales to customers
* Loans to clients, suppliers, distributors, and employees
* Business loan guarantees

When deducting a business bad debt, the deduction is figured through the taxable income that is based on your business's full or partial gross income.<ref name="irs.gov">{{Cite web|title=Topic No. 453 Bad Debt Deduction {{!}} Internal Revenue Service|url=https://www.irs.gov/taxtopics/tc453|access-date=2021-11-16|website=www.irs.gov|language=en}}</ref>

====Nonbusiness bad debts====
Nonbusiness bad debts are all other debts that are not business bad debts. To deduct a nonbusiness bad debt, it has to be completely worthless. A debt becomes worthless when it is reasonable to believe it will never be repaid after you have taken the steps to collect it. The deduction can only be taken in the year that the debt is determined to be worthless.<ref name="irs.gov"/>

====Mortgage bad debt====
Mortgages that may be non-collectible can be written off as bad debt as well. However, they fall under a slightly different set of rules. As stated above, they can only be written off against tax capital, or income, but they are limited to a deduction of $3,000 per year. Any loss above that can be carried over to the following years at the same amount. Thus a $60,000 mortgage bad debt will take 20 years to write off.<ref name="Form 1040">{{cite web|url=https://www.irs.gov/pub/irs-pdf/i1040sd.pdf|title=www.irs.gov/pub/irs-pdf/i1040sd.pdf|access-date=6 June 2016}}</ref> Most owners of junior (2nd, 3rd, etc.) fall into this when the 1st mortgage forecloses with no equity remaining to pay on the junior liens.

There is one option available for mortgages not available for the business debt: donation. The difference is that a valuation of $10,000 can be taken without an appraisal. An appraisal may be able to increase the value to more and must be based on other similar mortgages that actually sold, but generally it is less than the face value. The real difference is that as a donation the amount of deduction is limited to up to 50% of adjusted gross income per year with carryovers taken over the next five years.<ref name="Pub.526">{{cite web|url=https://www.irs.gov/pub/irs-pdf/p526.pdf|title=www.irs.gov/pub/irs-pdf/p526.pdf|access-date=6 June 2016}}</ref> This is because the deduction is now classified as a donation instead of a bad debt write off and uses Schedule A instead of Schedule D.<ref name="Form 1040" /> This can significantly increase the current year's tax reductions compared to the simple write off. The caveat is that it must be completed prior to the date of final foreclosure and loss. The process is simple, but finding a charity to cooperate with is difficult since there will be no cash value as soon as the 1st mortgage forecloses.

====Problem loan====
Problem loans are loans that borrowers do not pay back because they are unable to or do not want to. These loans arise due to banks giving excess loans, loans with difficult repayment terms, and improper documentation.<ref>{{Cite journal|last=Parvin|first=Afroza|date=2017|title=Determinants of Problem Loans and its Effects on the Financial Health: Evidence from Private Commercial Banks of Bangladesh.:|journal=Welcome Message from Conference Chairs.|volume=1}}</ref>