Bad debt is an amount owed to a business that it no longer expects to collect. After collection efforts fail, or a customer goes bankrupt, the business writes the receivable off as an expense.
How it works in factoring
Who absorbs a bad debt on a factored invoice depends on the agreement:
- Recourse factoring: the seller bears the loss. The factor charges the unpaid invoice back, usually against reserves, and the seller writes it off.
- Non-recourse factoring: if the loss results from a covered credit event, such as an approved customer's insolvency, the factor absorbs it within the approved limit.
- Disputes and dilution: losses arising from returns, quality complaints or billing errors are usually the seller's responsibility in either case.
Accounting treatment also differs. Businesses following accrual accounting often estimate bad debts in advance with an allowance for doubtful accounts, then charge specific write-offs against it. For tax purposes, the rules for deducting business bad debts are set by the Internal Revenue Code and IRS guidance.
Why it matters
Bad debt directly reduces profit, and a pattern of uncollectible accounts makes financing harder to obtain. Factors look at your history of write-offs as a signal of customer quality and credit practices.
What to check
- Your historical write-offs as a share of sales
- Which customers have caused losses and whether you still extend them credit
- Whether non-recourse factoring or credit insurance would cost less than expected losses