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In layman’s language, Bad Debt is an expense incurred by a business, which is not repaid by the debtor, in the due course of time for reasons such as fraud, insolvency of the debtor, etc. We can also refer to it as Uncollectible Accounts Expense and Irrecoverable Debts.
Meaning of Liability
Liabilities refer to the financial obligations of a business. In simple words, it is a sum of money owed by a debtor to a creditor under an agreement and repayable on a specified period. For example, Bank Loans, Accounts Payable, Bank Overdrafts, etc.
Bad debts are an expense or a liability?
Bad Debts are an expense to the business and not a liability as the amount that was expected to be received from the debtor is irrecoverable and has a negative effect on the books of accounts by way of reduction from the accounts receivable.
It is recorded on the asset side of the balance sheet however, it is entered in the balance sheet as a contra asset account i.e. as a reduction from the accounts receivable. It is also recorded under operating expenses in the Income Statement as well as in the profit and loss a/c on the debit side.
Therefore, we can easily conclude now that bad debts are an expense and not a liability.
This concept is further explained with an example stated below.
XYZ Ltd sells machinery to ABC Ltd. for 10,000 at 60 days credit. However, ABC Ltd is declared bankrupt and therefore can no longer pay the specified amount. This amount of 10,000 is an expense for XYZ Ltd and leads to a fall in the accounts receivables. Hence, it is not a liability for the company but an expense.
Bad debts as shown in the Income statement
(Extract of the Income statement)