If your business sells products or services to customers on credit, then you run the risk of dealing with bad debt. Simply put, a bad debt is money owed to your company by a customer that you have unsuccessfully tried to collect to the point where you decide the debt is uncollectible and it is written off. It's certainly not a great situation, but it's important to know what a bad debt is, why it can happen, and how you should go about recording it in your company's accounting. Making sure this kind of situation is dealt with correctly will prevent accounting hiccups and give you a more accurate picture of your company's financial health.
Why Does Bad Debt Happen?
Bad debt can happen for a number of reasons. One of the most common occurs when a customer goes into bankruptcy and their assets have been liquidated (sold off or redistributed). It can also happen in the case of a dispute over the delivery or condition of a product. Financial stress or cash flow problems can also be the culprits. (Want to read up on cash flow? Check out our recent blog post, What is Cash Flow and Why is it so Important?)
Keeping a Bad Debt Allowance
So how can you prepare for bad debts and protect your company's finances from taking a hit? Setting up a bad debt allowance (aka a bad debt reserve or allowance for uncollectibles) is a standard accounting procedure designed to do just that. A bad debt allowance is a type of contra account designed to offset your company's assets: if a debit is recorded in the opposite account (in this case, assets), then a credit is recorded in the contra account (the bad debt allowance account). (For a basic run-down on debits vs credits, be sure to check out our post, What is a Debit and Credit in Accounting?)
How much money should be allotted to your bad debt allowance? Good question. Your company's management should be able to estimate how much of your Accounts Receivable (aka, bills owed to you by your customers) will go unpaid based on the business' financial history. (Get a refresher on Accounts Receivable.)
Let's look at a brief example. Say your company has an Accounts Receivable (aka receivables) balance of $10,000, and you have been able to work out from past financial records that 1 percent of your receivables will end up being uncollectible. This means that you should maintain a bad debt allowance of $100 (since 1 percent of $10,000 is $100). When it comes to drawing up your balance sheet, you will record $10,000 in receivables, which is offset by an allowance of $100, giving net receivables of $9,900.
Writing Off Bad Debt
Continuing on with our example above, let's say you have been trying to collect a debt of $50 from a customer. You've done everything you can and your efforts have been exhausted. Now you will want to write off this amount as a bad debt. You will need to reduce both Accounts Receivable and your bad debt allowance by the amount of the bad debt ($50), in this case leaving you with $9,950 in receivables and $50 in bad debt allowance. Your net receivables will remain the same ($9,900), and your profitability will not be affected. Why? Because you have already accounted for the bad debt amount and expensed it in your company's bookkeeping.
While having unpaid bad debts from customers is not an ideal situation, it's important to know how to track it in your company's bookkeeping to avoid future headaches. And some write-offs may even be tax-deductible, so it's worth staying on top of bad debts with the right accounting software!
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