When most people hear the word ‘debt’, they automatically feel a sense of worry and unease, regardless of the context or situation. It is a common misconception; indeed, many forms of debt can be considered beneficial to the consumer or business, commonly referred to as good debt.
However, where there is good, there is almost always bad. That is certainly true when it comes to debt. According to recent figures, of the $2 trillion of total personal debt accrued by Australian households, 7.2% is considered bad debt and detrimental to individuals and businesses.
While the total figure may seem small, not accounting for bad debt can have devastating consequences for those in the grips of it. That is why it is vital to take control of bad debt as quickly as possible.
Let’s get to the following commonly asked questions:
Whenever a consumer takes out personal loans, credit card, real estate mortgage, or other loans, they do so under the proviso that they will be able to manage the repayments and account for the interest accrued over time.
Bad debt occurs when a consumer or business can no longer make these repayments, rendering the debt an irrecoverable receivable.
Businesses risk running into bad credit when they opt to offer too much-extended credit to their customers and don’t make an allowance for bad debt. They can also run afoul of unpaid invoices or delayed invoice payments required to satisfy their own debt commitments.
For the individual, bad debt is often the price paid for short-term financial solutions that carry obscenely high-interest rates.
There are three main types of financial arrangements where bad debt is likely to occur.
Credit cards remain a hugely viable source of personal finance for many Australians, though they are a common bad debt expense. Between August 2020 and July 2021, the value of credit sales and purchases in Australia was estimated to be just over $300 billion.
While interest rates for credit cards can be low, long-term accumulation of interest and missed payment penalties can make them unmanageable for those struggling. Prolonged use of credit cards can also negatively affect an individual’s credit score, especially if there is no sustained effort of bad debt deduction.
Still, when used sensibly, credit cards can serve an important purpose for many people. If you are considering signing up for a credit card, be sure to check out our credit card comparison tool to find the card best suited for your needs.
The most damaging form of bad debt often occurs through payday loans. These involve an instant cash injection from the provider that will go straight into a customer’s bank account. However, they usually come with frequent repayment due dates and exceptionally high interest rates.
Unless you have the necessary cash flows to be able to pay back this type of loan very quickly, you should avoid this form of financial aid.
The final predominant source of bad debt comes from car loans. This is because, unlike a home that will often appreciate in value, a vehicle will quickly depreciate after purchase and won’t result in a net gain in a person’s financial assets.
NOTE: This final form of bad debt will only occur for vehicles intended for day-to-day use. Rare vintage cars can gain value over time, so if a loan is used for this type of purchase, it may ultimately result in good debt.
Another important type of recorded bad debt is income tax debt with the Australian Taxation Office. This is where the person or business hasn’t paid the right amount of tax on related revenue over the accounting periods in the year, and as such, they owe money to the ATO at tax time. When this becomes a late payment, it becomes bad debt, and can impact your chance of getting financial assistance for other personal or business expenses.
There are two main methods of recording bad debt expenses.
The first method is known as bad debt write-off. The direct writeoff method can be used if you are confident there is an irrecoverable debt on one of your accounts. The method involves debiting the bad debt expense for the total write-off amount. You would then credit the receivable accounts for the same amount.
For a business, writing off bad debt is often beneficial for tax purposes, as these write-offs can be listed as losses for financial statements and tax return purposes.
The second method is known as a bad debt provision or an allowance for doubtful debt accounts. With this accepted accounting method, rather than having a known irrecoverable debt, you would need to estimate the amount of bad debt you believe you’ll need to write off over a given period and treat this as a bad debt reserve.
This estimated amount will be charged to the accounts receivable and debited as a bad debt expense. It will then be credited to a bad debt provision contra account.
When it comes to any aspect of your finance, risk management and social responsibility are both required when taking on any form of debt.
You’ll need to carefully research whether the debt you take on is financially viable and that you’ll be able to afford the repayments comfortably.
Set up recurring payments, make an allowance for doubtful accounts, and separate your corporate finance from nonbusiness bad debts.
If you need to enter into some form of bad debt, you should try to make sure that you exit the period with some form of appreciative asset or financial gain. For example, if you take out a credit card but remain completely on top of your repayments, you will be rewarded with a high credit score.
This can lead to higher approval rates for good forms of debt, such as personal or business loans or a mortgage for your first home.
NOTE: Keeping track of debt is part of all accounting processes, and the use of a Single Touch Payroll system or similar can ensure you are keeping up to date with how much debt you have, and how much you need to pay, in certain accounting periods.
As previously mentioned, there is such a thing as good debt, and when handled sensibly, this form of personal finance can go a long way toward a strong financial future.
For example, a mortgage is considered the best form of good debt. This is because a house is considered an appreciating asset. Once a mortgage has been repaid, you will own something of higher value than what it was when you made the initial purchase. In other words, the debt has enabled you to make money!
Understanding bad debt is vital for any prospective business owner or individual needing financial assistance. There will always be unscrupulous companies looking to take advantage of those in trouble by offering instant cash and unmanageable interest rates.
While this may be tempting and may solve short-term issues, bad debt that grows out of control can greatly impact your long-term financial prospects. Make sure you are fully aware of all permeations before committing to this form of finance.
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Disclaimer: The author is not a financial advisor and the information provided is general in nature and was prepared for information purposes only. This article should not be considered to constitute financial advice. Accordingly, reliance should not be placed on this article as the basis for making an investment, financial or other decision. This information does not take into account your investment objectives, particular needs, or financial situation.