Estimating and managing bad debt in accounting can seem complicated for business owners. The good news: once you have a process for identifying and managing bad debt, it becomes far less intimidating.
In this guide, you'll learn why bad debt occurs, how to estimate it and different management strategies.
What is bad debt?
Bad debt is money a customer owes you that can’t be collected.
Debt is a natural part of doing business and occurs when you extend credit to a customer, usually by providing goods or services before payment has been collected. It turns into bad debt when it becomes clear that you're not going to receive payment. In accounting, bad debt needs to be recorded as an expense on your balance sheet to reflect the fact that expected income wasn’t paid.
Why do bad debts occur?
Bad debts occur for a wide range of reasons. More often than not, bad debt is a result of circumstances beyond your control, such as cash flow problems, bankruptcy, death or fraud. For example, if your client's business gets into financial difficulty after your business has already delivered services, it could result in unpaid debt.
In other cases, bad debt can be the result of extending credit to an unsuitable customer. You can avoid this kind of bad debt by making sure you have effective customer screening processes in place alongside credit limits and clear terms and conditions.
Accounting for bad debts
Accounting for bad debts can be done differently depending on whether you record your income using accrual accounting or cash accounting. Here are the key differences between the two in relation to bad debts:
Cash basis
Cash basis accounting is a method that records income only when it's received. This means that you don't need to make any adjustments when an unpaid invoice becomes a bad debt, because the debt was never included in your business income. In this situation, there are no income tax consequences for writing off or forgiving a bad debt.
Accrual basis
Accrual basis accounting, sometimes called double-entry accounting, is more complicated than the cash basis method. Under this system, you record income in your accounting system when it's invoiced, then again when the amount is paid. This means, if an unpaid invoice becomes bad debt, you need to make adjustments in your accounting system to reflect this.
If you record your income on an accrual basis, you might include income in tax returns before you receive payment. This means that a debt can turn bad after the amount has been included as assessable income. You'll also need to remove the debt from accounts receivable and list it as an expense on your profit and loss statement. In some cases, you may be able to claim the amount of bad debt as a tax deduction.
How do you estimate a bad debt?
Knowing how to estimate bad debt is the first step toward effective bad debt management in your business. The two main methods you can use are the accounts receivable ageing method and the percentage of sales method. Let's look at these methods in more detail:
Accounts receivable ageing method
The accounts receivable ageing method focuses on how long debts have been unpaid, allowing you to prioritise your debt collection efforts. Aged debt reports, sometimes called aged receivables, list debt based on the length of time payments have been outstanding, giving you insight into possible bad debts and customers who seem to be struggling with payment. This information can help you decide whether to write off certain debts and or keep extending credit to specific customers.
Percentage of sales method
The percentage of sales method involves using data on previous debt patterns to estimate how many of your current invoices are likely to become bad debt.
Once you've worked out what percentage of your sales is likely to be uncollectible, you use that figure to estimate your potential bad debt for the coming year.
Here's the formula:
Total bad debt/total credit sales X 100 = % of bad debt
For example, if your business had $500,000 in sales per year, with an average of $10,000 in unpaid debts, the calculation would look like this:
10,000/500,000 = 0.02
0.02 X 100 = 2%
To estimate the percentage of bad debt for the coming year, you use the following formula:
Bad debt percentage X total credit sales = bad debt allowance
For example, if you estimate $550,000 in sales for the current year and your bad debt percentage is 2%, your calculation looks like this:
0.02 x $550,000 = 11,000
This means your business should plan for up to $11,000 in bad debt for the tax year by putting aside funds or reducing profit projections.
How do you record a bad debt?
To record a bad debt, you'll need to choose one of the following methods:
Bad debt write-off method
The bad debt write-off method is the easiest way to record bad debt. With this method, you write off a debt as a financial loss when you decide that it's not going to be paid. You record the write-off on your profit and loss statement, so it's easy to see exactly how much bad debt has occurred in a given period.
Bad debt allowance method
The bad debt allowance method is more complicated than the write-off method, but it allows you to prepare for anticipated bad debts in advance, rather than dealing with them as and when they come up. This method ties in with the percentage of sales method, which helps you estimate how much bad debt is likely during a given period.
By using the allowance method, you essentially create a fund to cover your estimated losses in bad debts. Then, when an unpaid invoice becomes a bad debt, you simply deduct the amount from your bad debt allowance.
Strategies to recover bad debt
Strategies to recover bad debt are an important consideration, especially for small businesses. If a client isn’t paying an invoice, there are several actions you can take to try and recoup the debt before it turns bad. Consider the following options before recording non-payment as bad debt:
Send overdue payment reminders
Send overdue payment reminders to customers with outstanding invoices to gently prompt them for payment. MYOB customers can use our accounting software to set up customised invoice reminders and statements of account to automatically go out to customers.
Make direct contact
Make direct contact with the debtor to chase up an overdue invoice and maintain a good client relationship. You may learn that they haven't paid your invoice due to severe financial hardship, in which case you could discuss possible payment plans to help you recoup the debt. In another case, a debt could have simply been forgotten or missed in their system, and a quick reminder could nudge them to complete the payment.
Send a formal letter
Send a formal letter to your customer when payment reminders and direct contact haven't resulted in payment. In the letter, you should include a clear description of the unpaid debt including the outstanding balance, due date, days overdue and the other steps you’ve taken to resolve the issue.
If necessary, you can use a formal letter to inform your debtor that you'll seek legal action if a debt isn’t repaid by a stipulated date.
Take formal action
If you run a businesses in New Zealand, you can also ask the courts to help you collect a debt. Read the justice ministry's guide to collecting civil debt to find out more about the process and fees
Bad debt tax implications
Bad debt tax implications can be hard to get your head around if you're new to business accounting, especially if you account for your income on an accrual basis.
If you record your income on a cash basis, you'll be pleased to know that there are no tax implications for writing off bad debts. This is because your tax returns only include payments you've already received, so writing off or forgiving bad debts won't change your recorded income.
On the other hand, if you record income on an accrual basis, you may claim a tax deduction for bad debts. This refers to payments you included on your last tax return but you've since written off due to the payments being deemed uncollectible.
If you account for goods and services tax (GST) on an accrual basis, you might also be able to claim a decreasing adjustment for bad debts. You can only claim a decreasing adjustment for sales on which you've already paid GST.
You can find out more about deductions for unrecoverable income (bad debts) on the IRD website.
Bad debt FAQs
What is the accounting entry for bad debt?
The journal entry for writing off bad debt is a debit to the bad debt expense account with the amount, and a credit to the accounts receivable account with the same amount. This is an example of double-entry accounting.
How do you record bad debts on a balance sheet?
You record bad debts on a balance sheet by debiting the amount to your bad debt expense account and crediting it to your bad debt allowance. This is only relevant if you’re recording bad debt using the allowance method.
If you've used the direct write-off method, you don't need to record bad debts on a balance sheet since you've already created an accounting entry for the debt.
What type of asset is bad debt?
Bad debt is classified as an expense.
Can a debt be forgiven?
Yes, a debt can be forgiven and happens most often when the debtor (the customer who owes you money) is under financial stress. When you forgive a debt, the customer is no longer obligated to pay.
A good way to manage bad debt
Managing bad debt can take valuable time away from running your business. Take the weight off your shoulders by using MYOB's accounting software to automate your invoicing and accounts receivable processes.
With customisable payment reminders, automatic invoice payment tracking, and a range of useful reporting functions, it can help you stay on top of overdue payments and minimise the disruption bad debts can have on your business.
Let MYOB handle accounts receivable so you can focus on growing your business. Get started today.
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