What It Is:
How It Works/Example:
For example, let's say Company XYZ manufactures bicycles and sells them through retail stores. Once the retailer receives the bicycles it has 90 days to pay Company XYZ. Company XYZ records the amount due as "accounts receivable" on the balance sheet and recognizes the revenue. However, as the 90 day due date passes, Company XYZ realizes the retailer is not ever going to make its payment.
Once it determines that it's a bad debt and won't be repaid, XYZ must make adjustments to its financial statements. Under accrual accounting, since revenue was already credited for the sale of the bicycles, Company XYZ must adjust its income statement for the bad debt. Therefore, Company XYZ has accounts for both allowance for doubtful accounts (ADA) and bad debt expense, which reduces the amount of net income reported by Company XYZ.
Companies have bad debt expense accounts because it is inevitable that some customers won't pay for the goods and/or services provided, usually occurs because the debtor declares bankruptcy.
For individuals, bad debt refers to debt that is not beneficial in the long run. While a mortgage is a form of debt, it is not considered bad debt, because the borrower has the potential to actually profit from an increase in their home's value. However, credit card debt and other forms of consumer debt are called bad debts, because they are debts taken on for consumption. Consumer goods almost always go down in value over time, so it's common to owe more on a credit card than the purchased goods are actually worth.
Why It Matters:
Bad debt, when it applies to transactions between companies, is an inevitable part of doing business. Ultimately, not all payments owed to a company will be paid, so all companies have accounts for bad debt expenses and allowance for doubtful accounts (ADA). Therefore when investors and other outside people evaluate a company based on its income statement, the figure for net income has already been adjusted for bad debt.
Bad debt that applies to individual consumers is a term for debt that is harmful to consumers. The harm can ultimately be reflected in the individual's credit score. Bad debt is a signal to creditors that an individual is at a higher risk for not being able to repay debt, so it is harder to acquire loans the more bad debt a consumer has.