Bad debt is an amount owed that a creditor does not expect to recover. Economically, it is realized credit loss; accounting-wise, it reduces earnings and asset values.
Core Mechanics
When a receivable or loan becomes uncollectible, firms either:
- write it off directly, or
- recognize an allowance and then charge specific losses against that reserve.
A stylized expected-loss framing is:
[ \text{Expected Credit Loss} = PD \times LGD \times EAD ]
where PD is probability of default, LGD is loss given default, and EAD is exposure at default.
Why It Matters
Bad-debt dynamics influence bank profitability, lending standards, and financial stability. Rising write-offs often signal weakening borrower balance sheets and tighter future credit supply.
Policy Context
During downturns, supervisors track provisioning quality to avoid delayed loss recognition. Underprovisioned systems can amplify recessions because banks abruptly cut lending once losses are finally booked.