Definition of Bad Debts

Bad debts are financial amounts owed to a company or financial institution that cannot be collected from customers or debtors. This term is one of the most important concepts in financial accounting and banking management, as it directly affects the profits and losses of institutions.

Understanding Bad Debts in the Accounting System

When a company sells goods or provides services on credit, it records these amounts as accounts receivable in its accounting books. Over time, it may face difficulties in collecting some of these amounts due to customer bankruptcy, disappearance, or refusal to pay. In this case, these amounts become bad debts that must be treated accounting-wise.

International accounting standards require companies to estimate doubtful debts and create an allowance for bad debts, ensuring that financial statements are presented fairly and truly reflect the actual financial position of the institution.

Causes of Bad Debts

Economic Factors

General economic conditions significantly affect customers' ability to pay. During periods of economic recession or financial crises, bad debt rates increase due to declining income, job losses, and business closures.

Weak Credit Policies

The absence of strict criteria for granting credit or failure to carefully study customers' financial situations leads to increased bad debt risks. Poor follow-up and failure to take collection actions at the appropriate time exacerbates this problem.

Customer-Specific Factors

These factors include customer bankruptcy or death, or exposure to exceptional circumstances that prevent them from paying. There may also be legal disputes regarding the quality of goods or services provided that lead to payment refusal.

Accounting Methods for Treating Bad Debts

Direct Write-Off Method

In this method, the company writes off the bad debt directly from accounts receivable and charges it to bad debt expense account. This method is simple but does not comply with the matching principle in accounting, as the expense is not matched with revenue in the same accounting period.

Allowance Method

This method is considered more accurate and compliant with accounting standards. The company estimates a percentage of total credit sales or accounts receivable as doubtful debts and creates an allowance to face these expected losses. When collection impossibility is confirmed, the debt is written off from the allowance rather than from profit and loss.

Impact of Bad Debts on Financial Statements

Bad debts affect several elements in the company's financial statements. In the income statement, they appear as an expense that reduces net profit, affecting the company's profitability and financial performance indicators. In the balance sheet, they reduce the value of accounts receivable, affecting total current assets and liquidity ratios.

They also affect the company's cash flows, as non-collection of these amounts reduces cash available for operating and investment activities. This impact extends to the company's ability to meet its obligations and invest in future growth.

Risk Management Strategies for Bad Debts

Comprehensive Credit Assessment

Companies should establish a strict system for evaluating customers' creditworthiness before granting credit. This includes studying credit history, financial position, and ability to pay, and using credit rating agencies to obtain reliable information.

Customer Portfolio Diversification

Not relying on a limited number of large customers reduces concentration risks. Distributing credit sales across a broad customer base mitigates the impact of any single customer's non-payment on the company's overall financial position.

Continuous Monitoring and Early Collection

Establishing an effective system for monitoring accounts receivable and reminding of due dates helps reduce delay periods. Early intervention when signs of payment difficulty appear increases collection chances and prevents problem escalation.