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What is Bad Debt?

What is Bad Debt?

Bad Debt Definition

Bad debt occurs when you lend money, and the borrower fails to repay you. An uncollectible debt often happens in business transactions where you provide goods or services on credit. When the customer doesn't pay the invoice, the amount becomes a loss for your company because you've expended resources without receiving the expected financial return.

Challenges Due to Bad Debt

A business bad debt challenges your financial stability and growth. 

  • Cash Flow: It directly impacts your cash flow. You can find it challenging to cover your expenses or invest in new opportunities without the anticipated payments. This situation can force you to dip into your bad debt reserve or seek additional financing, potentially at a high interest rate, to keep operations smooth.
  • Profit Margin: The revenue you counted to offset the costs of goods sold (COGS) or services provided won't materialize, reducing your overall profitability and affecting your profit margin. This scenario can distort your financial planning and analysis, leading to skewed budgets and financial strategies.
  • Time and Resources: Managing bad debt requires time and resources. You will need to engage in collection efforts, negotiate payment plans, or write off debts, each demanding attention that you could spend on more productive activities. Moreover, if the amount of bad debt is significant, you must hire financial services or collection agencies, incurring further costs.
  • Business Relationship: Additionally, bad debt can affect your business relationships. It could lead you to tighten credit terms, inconvenience your good customers, and strain those relationships. The experience of dealing with outstanding accounts can be frustrating and demotivating, impacting morale. 
  • Credit Rating: A high level of bad debt can harm your business's credit rating. Lenders and suppliers can view your business as a higher risk, which could lead to less favorable credit terms or difficulty securing future financing. This challenge can limit your ability to expand or invest in new ventures, constraining your growth prospects.

Recording Bad Debt

To record bad debt on the balance sheet, you first need to determine that a debt is indeed uncollectible. This means that after all attempts to collect the payment have failed, you accept that you can't recover the money. Once you reach this conclusion, follow these steps:

Use the Direct Write-off Method or the Allowance Method 

The direct write-off method removes the uncollectible amount from your accounts receivable. In contrast, based on historical data, the allowance method involves setting aside an estimated amount for potential bad debts in advance.

For the Direct Bad Debt Write Off Method

  • Debit the Bad Debt Expense account to increase your expenses.
  • Credit the Accounts Receivable account to decrease your accounts receivable. This action reflects the loss directly in your financial statements when you determine you can't recover the debt. 

For the Allowance Method

  • Debit the Bad Debt Expense allowance account.
  • Credit the Bad Debt Allowance for Doubtful Accounts. This bad debt provision creates a contra account that reduces your total accounts receivable, showing what you realistically expect to collect.

Adjust Entries at the End of the Period 

If using the allowance method, review your bad debt estimate at the end of each accounting period and adjust entries if necessary. This ensures your allowance matches actual bad debt, keeping your financial statements accurate.

Document Everything 

Keep detailed records of your attempts to collect the debt, your decision-making process for deeming it uncollectible, and the accounting entries made. This documentation is crucial for audits and analyzing your credit policies and customer payment behaviors.

Estimating Bad Debt

To estimate bad debt, you need a strategy that reflects your business's experience with customer payments and industry standards. Here’s how you can approach it:

  • Percentage of Sales Method: Start by analyzing your historical sales data and the percentage of those sales that typically turn into bad debt. Apply this percentage to your current sales to estimate your bad debt. For example, if historically, 2% of your sales have been uncollectible, and this year's sales are $100,000, you would estimate $2,000 as bad debt.
  • Aging of Accounts Receivables: Review your AR aging report based on how long invoices have been outstanding. Different age categories (e.g., 0-30 days, 31-60 days, 61-90 days, and over 90 days) can have different likelihoods of becoming bad debt. Apply different percentages to each category based on past experiences. For instance, you can estimate a 5% bad debt rate for accounts 31-60 days old but a 20% rate for accounts over 90 days old.
  • Specific Identification Method: Look at each outstanding invoice individually and evaluate the likelihood of collection based on specific factors, such as the customer's payment history and current financial status. This method is more time-consuming but can provide a more accurate estimate for businesses with fewer large accounts.
  • Historical Percentage Method: Use your business's overall bad debt percentage for your estimate. This is a broader approach than the percentage of sales method and considers all receivables. 
  • Industry Comparison Method: Compare your bad debt experience with industry averages. If you're new to the business or need more historical data, industry benchmarks can provide a starting point for your estimates. Adjust these benchmarks based on specific factors that can make your business more or less likely to experience bad debt than the average.

How to Prevent Bad Debt

You must proactively safeguard your finances while maintaining healthy customer relationships to prevent bad debt. Here's how you can do it:

  • Conduct Credit Checks: Conduct thorough checks before making credit sales to new customers. This helps you assess their ability to pay and determine appropriate credit limits.
  • Establish Clear Credit Policies: Set and communicate clear credit terms from the start. This includes payment deadlines, interest rates for late payments, and consequences for non-payment. Make sure your customers agree to these terms before providing goods or services.
  • Use Credit Score: Have customers fill out a credit application form. This collects essential information about them and formally documents their agreement to your credit terms.
  • Invoice Promptly and Clearly: Send invoices when goods or services are delivered. Ensure that your invoices are clear and accurate and include all necessary details like payment terms, due date, and how to make a payment.
  • Implement Regular Follow-ups: Monitor your accounts receivable closely. Follow up with customers as soon as payments are late. A systematic approach to reminders can help secure payment before the debt becomes problematic.
  • Offer Multiple Payment Options: Accepting various payment methods makes paying accessible for customers. The more convenient it is to pay, the less likely customers are to delay.
  • Establish a Bad Debt Reserve: Recognize that some bad debt is inevitable. Set aside a reserve based on historical data and industry standards to cover potential losses without impacting your financial stability.
  • Review and Adjust Credit Policies Regularly: Regularly review the effectiveness of your credit policies and adjust them based on your experiences. Tightening or loosening the credit sale based on customer payment behaviors can minimize bad debt.
  • Consider Third-Party Assistance: For customers who consistently pay late, consider using a collection agency or offering them to a factoring company. These options can help you recover some of the owed money without expending too much internal time and resources.
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