Bad debt occurs when a company determines that an accounts receivable or a loan cannot be recovered from the debtor. This situation often happens when a customer or entity goes bankrupt, dissolves, or is unable to pay due to financial hardship. Recognizing bad debt is important for accurate accounting and financial reporting as it ensures assets are not overstated.

For example, if a business sells goods on credit to a customer who later files for bankruptcy, the outstanding amount due from that customer would be classified as bad debt. Businesses might try collections processes to recover as much as possible before writing the amount off.

Bad debt is recorded as an expense in the company's income statement and can impact the company's net income. Companies may also establish an allowance for doubtful accounts to anticipate potential bad debts upfront. Best practices include regular reviews of accounts receivables and implementing credit checks for customers.