Question

describe a bad debt for taxation purpose. Example

Answer 1

Bad debt—or an uncollectible account—is a receivable owed by a customer, client, or patient which the business owner or creditor is not able to collect. Bad debts may be written off by the creditor at the end of the year if it is determined that the debt is uncollectible.

The IRS says bad debts include:

Loans to clients and suppliers

Credit sales to customers

Business loan guarantees

Bad debts are taken off the business income at the end of a year. In order to write off bad debts, your business must use the accrual accounting method. Under this method, you show income when you have billed it, not when you collect the money.

If your business operates on a cash accounting basis, you can't deduct bad debts because in cash accounting you don't record the income until you have received the payment. In this case, you just don't receive the income, so there is no tax benefit to recording a bad debt.

This can be explained with an example

You sell $5,000 of products to a customer.

Under the cash accounting method, you only record the sale when you receive the money from the customer. If the customer doesn't pay, you don't record the sale. So, at the end of the year, if you haven't been able to collect the money, there is no bad debt because there is no sale recorded.

Under the accrual accounting method, you record the sale at the time you billed the customer. So your sales records for the year include the $5,000. If you determine that you are not going to be able to collect this $5000, you must manually take the amount out of your sales records before you prepare your business tax return.