A charge off to a bad debt occurs when a company determines that money owed to it is unlikely to be paid. In order to balance the company's ledger, the debt is "written off" the books. Although a charge off to a bad debt does not mean that the debt is no longer owed, the date of a charge off has important value to debtors.
It is important for debtors to know what it means when a creditor charges off a debt that has not been paid. Many people believe that a charged off debt does not need to be repaid. This is a misconception. A charge off to a bad debt is a company's internal way of balancing its books and to take advantage of an IRS rule. Companies continue to pursue payment for charged off debts.
The Internal Revenue Service allows creditors to charge off debts that are unlikely to be paid. The IRS rule, the "Specific Charge-Off Method," is a way for a company to take a loss for income tax purposes. If the company subsequently collects on the debt, it must declare that income to the IRS. Bad debts are written or charged off as a way for a company to balance its income sheet.
Technically, a company charges off a debt for two reasons. One form of a charge off is when a company reconciles its ledger in the event of a bad debt. When an outstanding debt is not paid, the creditor must reconcile the debt as a loss. A second type of charge off is when a company faces an extraordinary expense that causes a reduction in the firm's assets. An extraordinary expense is an expense that only occurs once on an income statement. Expenses that occur as the result of a calamity that causes hardship to a company are extraordinary.
When a company has failed to collect an outstanding debt, it must account for the loss of payment. When a bad debt is charged off, this is a time when a creditor may sell the debt to a collection agency. The money received for the debt is categorized as a sale. A creditor also can list the debt itself as an expense on its income statement. That charge off to a bad debt has a effect on the future of the debt as it relates to the debtor.
Debtors tend to misunderstand the implications of a charge off to a bad debt. Once a creditor charges off a bad debt, the firm continues to pursue collections and, eventually, it will sell the debt to a third party collector. The Fair Credit Reporting Act demands that the debt must be removed from the debtor's credit report seven years from the date of the charge off. A charge off occurs 180 days after the first default on a payment. The federal law means that debtors have a resource with which to act against unscrupulous collections agents and litigators. Debtors should keep all statements and notices because creditors must report a charge off in 90 days to credit bureaus.