One of the factors that a business must account for in estimating and calculating their earnings is the portion of their collectibles that will not be paid. This number for a company is called bad debt expense. For every dollar that a company is owed, they must estimate an amount that will not be collected.

This could be for a variety of reasons. In many businesses, their customers are other businesses. A supplier might sell an item that they manufacture to a retailer, but if that retailer goes out of business before paying off their obligations, their debt to the supplier may never be paid. If your customer is an individual consumer, factors such as extended illness, loss of employment, or personal bankruptcy might make the debt impossible to collect.

Companies account for bad debt by estimating the amount of their outstanding receivables that will be uncollectible in each accounting period. Bad debt is considered an expense when it comes to generally accepted accounting principles, thus reducing net income. There are consequences for both business and consumers when it comes to bad debt expense, and there are steps that a company can take to reduce that amount of debt that goes uncollected.

Companies have the right to dictate the terms of the credit they extend. Being flexible in giving consumers a long period of time to pay their account balance may be nice from a customer relations standpoint, but it can lead to headaches for the accounting department as cash flows stall and bad debt piles up. Tightening credit terms so that debts must be paid in a shorter amount of time can help a company determine which of their receivables may go uncollected.

It also could scare away consumers that aren't confident in their ability to pay on time, and these are consumers that you probably don't want owing you money in the first place. A cost of bad debt expense for consumers is that even good borrowers might be asked to adhere to strict credit terms due to the few bad borrowers that fail to pay.

One of the challenges of accounting for bad debt expense is knowing when an obligation is truly bad debt instead of just late or partial payments. A company needs to clearly define the circumstances in which bad debt will be written off the books and to develop a plan for seeking to collect on the debts that remain in place on the books. A company also needs to decide how they will qualify borrowers.

For debts that appear to be bad, it's possible to sell these receivables to outside companies who will assume the risk of the debts going uncollected. This business is known as factoring, and items done by bundling a portion of accounts receivable and selling them at a discount to a company that will work to collect them all.

Bad debt expense is an unfortunate cost of doing business, but taking steps to keep exposure low can increase profitability for a company.