Bad debt is money that customers owe you but are unlikely or unable to pay. When a company determines that a receivable is uncollectible, it writes it off as a bad debt expense.
For example, if you sold $20,000 worth of goods on credit to a customer who later goes bankrupt, that $20,000 becomes bad debt. The company records it as an expense, reducing both accounts receivable and net income.
Companies estimate bad debt using two methods: the direct write-off method (written off when confirmed uncollectible) and the allowance method (estimated in advance based on historical data). The allowance method is preferred under GAAP.