What is a Bad Debt?
Bad debts are a reality for any business that extends credit to its customers. Bad debt is money owed by a customer or client that the company cannot collect on. It’s an amount of money the company has lent out but will never see a return.
This can significantly impact businesses as it reduces their cash flow and profits, affecting their ability to operate successfully. Understanding bad debt and how it works is essential for all businesses to prevent or minimise losses from uncollectible accounts receivable or sales ledger.
In this article, we will look at types of bad debt, how to reduce bad debt and how to record bad debt expenses in the accounts.
Definition of Bad Debt
Bad debt is a loss incurred by an organisation when it lends money or extends credit to another company, individual, or entity, and the debt is not paid back.
Types of Bad Debt
Business debt can come in many forms, and it’s essential to understand the various types of bad debt so that a business is better equipped to prevent or minimise losses. Common bad debt types include bankruptcy, fraud, insolvency, death and disability. In addition, there are also non-payment debts from customers who don’t pay their bills on time or at all.
Causes and Consequences of Bad Debt
Many factors, such as poor credit policies, inadequate customer screening and verification procedures, unreliable collection methods, and rapid or excessive growth, can cause bad debt. It is also important to note that bad debt directly affects a company’s profitability.
For example, a company with too much bad debt can significantly reduce its profits. If a company’s sales ledger is too high, it can lead to cash flow problems and put the business at risk of insolvency or bankruptcy.
Therefore, it is important for companies to minimise bad debt by implementing effective processes such as credit checks and payment terms that encourage timely payments.
Companies need to have a strategy to deal with bad debt and ensure that they take the appropriate steps to recover what is owed. This includes seeking legal action and writing off uncollectible accounts receivable as a business expense.
How to Avoid Taking on Too Much Business Bad Debt
To avoid taking on too much bad debt, businesses should ensure that they always conduct credit checks on potential customers before extending them credit and also get a signed credit agreement or terms of contract. This will help them to identify which customers are more likely to default and allow them to assess the risk of offering a certain amount of credit.
Businesses should also set payment terms and make sure that customers understand them so that they know when payments are due. This will help to ensure that customers pay their bills on time and reduce the chances of late payment or default.
Strategies for Managing Existing Bad Debts
For businesses that already have existing bad debts, developing a strategy for managing and recovering them is essential. This includes developing a system for tracking overdue payments and setting up reliable collection processes.
Using accounting software can help with the process by giving businesses real-time access to financial statements, detailed customer accounts and enabling them to track outstanding invoices more efficiently. Accounting software can automatically send out customer statements and reminder letters.
Businesses should also consider seeking legal action against customers who are slow in their payments or who have defaulted on their debts. This may include sending letters of demand or even taking the customer to court if necessary. Learn how to make a court claim.
Benefits of Reducing or Eliminating Your Business’s Bad Debts
Reducing or eliminating bad debt can bring numerous benefits to a business, from improved cash flow and better sales ledger management to reduced time spent chasing customers.
By taking steps to minimise the amount of bad debt in their business, companies can ensure that they can focus more on growing their business instead of dealing with unpaid bills.
How to Write Bad Debts Off
Once a debt has been deemed uncollectible, businesses must decide whether to write it off or keep it in the accounts receivable. Writing bad debts off is usually preferable as this allows companies to immediately deduct the loss from their taxes and remove them from the balance sheet.
Writing a debt off involves recording a journal entry that reduces the sales ledger balance by the amount of the uncollectible debt. It is important to ensure that all taxes and other legal obligations related to writing off a bad debt are met before doing so.
Businesses should also consider implementing risk management strategies to help them avoid taking on too much bad debt in the future.
Accounting for Bad Debt
To keep accurate accounts and ensure compliance with tax regulations, businesses must ensure that bad debt is recorded correctly. There are two ways of recording a bad debt expense, which are bad debt write-off and bad debt provision. The accounting method you use will depend on the debt.
Bad Debt Write Off
Bad debt write-offs are used when a debt has become completely uncollectible. The direct write-off method involves recording the amount of the debt as an expense in the current period and reducing the accounts receivable asset account by the same amount.
Example Journal for a bad debt write-off:
| Debit | Credit | |
| Bad Debt Expense | 500.00 | |
| Accounts Receivable | 500.00 |
Bad Debt Provision
Bad debt provision is used for doubtful debts. This method involves recording an estimate of the amount likely to be uncollectible and creating a provision for a bad debt account.
At the end of a period, it is essential to go through the sales ledger, check any doubtful accounts, and complete a provision if required.
Below is an example of a bad debt provision.
| Debit | Credit | |
| Bad Debt Expense | 500.00 | |
| Provision for Bad Debt | 500.00 |
Provision for bad debt is a contra-asset account on the balance sheet.
By correctly accounting for bad debts, businesses can ensure that their accounts are accurate and compliant with the relevant regulations.
Allowance Method
The allowance method is another way of accounting for bad debts. This involves recording an estimate of the amount likely to be uncollectible as a provision and adjusting this figure at the end of each period based on actual experience.
For example, if a company has estimated that 5% of their outstanding balances on the receivables may not be collectable, then 5% of their total accounts receivable is recorded in an allowance for bad debt provision account at the end of each period.
Bad Debt Conclusion
Bad debt can harm any business, but companies can minimise their exposure to bad and doubtful debt by taking the proper steps and implementing effective strategies. This includes setting up reliable collection processes, using accounting software to track overdue payments, seeking legal action against customers who are slow in making payments and writing off uncollectible debts when necessary.
These preventive measures will help your business maintain good cash flow while reducing the time spent chasing delinquent customers. With the appropriate risk management strategies in place, companies should be able to reduce or eliminate their bad debt and focus more of their efforts on growing their company.
