A bad debt is an amount owed which has been written off because the entity that owes the money is unable to pay, or the business is no longer able to collect the amount due. It is counted as a loss or expense and is declared written off when the business has done everything in order to collect, but in vain.
The business or lender may have to consider the money owed a bad debt when the borrower declares bankruptcy, if contact with the borrower can no longer be made, or if collection expenses exceed the amount owed. In the case of a regular transaction between a supplier and a client, payment may be withheld if the products delivered do not correspond with those agreed on, if goods do not seem to be in the right condition, or if the client encounters financial difficulty and is no longer able to continue payment. In such cases, the client or the borrower will probably be disallowed from borrowing or purchasing again from the same business or lender.
There are many companies that set aside an allowance for bad debt. One way of determining the amount to be set could be by checking previous records of bad debt over a particular period of time. This information can help the business come up with a reasonable estimate and set this allowance.
In the case of banks, it is possible for a high profit to be made even while declaring bad debt. This is because all customer debts incur interests and penalties, depending on the delinquency of the debtor.