What happens when you run into a situation where a customer cannot pay the money they owe you? We certainly hope that you don’t. But just in case you do, you’ve got yourself a bad debt that needs to be dealt with. Some people may be familiar with bad debt expense, while some are completely oblivious to it. In this article, we’re going to cater to both. We’re going to show you everything there is to know about bad debt expense. These are referred to as debt because they present a negative void in your net income since you can’t make up for the lost amount.
What is Bad Debt Expense?
First, let’s define what lousy debt expense is and why it impacts you and your business. Bad debt expense is accounts receivable that you cannot collect because your customer or customers failed to fulfill their financial statements. There are two methods of calculating expense bad debt: the allowance method and the direct write-off method.
Bad debt expense is losing money because the customer does not pay immediately for the goods sent or services rendered. It’s a record that is reflected in a business owner’s financial statements as a credit loss.
Finding Bad Debt Expense
Businesses that offer products and services on credit are always at risk of bad customers who fail to pay their bills. Bad debt expenses come from these unpaid bills. After multiple failed attempts at collection, the business will then consider being non-collectible. Thus, it falls under lousy debt expense.
The option to write off an unpaid customer invoice will depend on the owner’s decision. However, if the customer is purposely avoiding calls, and their outstanding balance has gone unpaid for over 90 days, it will become mandatory to write off the invoice as bad debts.
Unpaid invoices hurt you in the long run. That’s why you need to write it off to give you a better view of your business’s financial statements. By writing off debt, you can avoid overstating your revenue, assets, and earnings.
If you have a good number of customers who have fallen in the bad debt expense category, it’s also best to flag them from ever transacting from you again. That way, you can avoid repeating your mistakes by putting your trust in shady and unreliable customers.
Calculating Bad Debt
To calculate bad debt expenses, you need to choose among wrote-off or allowance for doubtful accounts method. To know how to calculate bad debts, let’s get to know more about them.
Direct Write-Off Method
The direct write-off method involves the situation where the invoice amount is charged directly to bad debt expense and removed from the account receivable. Once it becomes clear that a customer invoice will not be paid, the invoice amount will be considered a bad debt expense. Because of this, it will then be removed from the account receivable. The account containing the bad debt expense will then be debited, while the account with accounts receivable will be credited.
Since it’s the direct write-off method, there will be no allowance account involved. The reason why there are two ways to calculate bad debt expense is that there are certain downsides to each one that needs to be addressed. For direct write-off, it fails to keep the generally accepted accounting principles (GAAP), as well as the principles, use in accrual accounting.
In this rule, an expense must be acknowledged during a transaction instead of when payment is made. That also means while it’s one of the two methods for calculating bad debt, it’s not the most accurate.
The allowance method uses anticipation to determine bad debt even before they occur. In this method, an allowance is established for doubtful accounts based on an estimated number. In other words, this method gives an allowance for doubtful accounts. This figure is the amount of money that a business anticipates to lose every year – otherwise known as a contra asset.
When listed on the balance sheet, the account containing the contra-asset reduces the account containing loan receivable. That means when both accounts record sales transactions; it also records a related amount of bad debt expense. The allowance for doubtful accounts will be the same.
This record is then considered a debit to the bad debt expense account and credit (allowance) for doubtful accounts. The unpaid accounts are then reduced to zero at the end of the year by depleting the amount in the allowance account.
Among the two, the allowance for doubtful accounts method is more compelling and accurate. It offers a cushion – an estimate – that will enable the business to predict how much it loses instead of waiting for the actual amount.
Methods for Estimating Bad Debt
According to the GAAP, there are two ways to estimate bad debt:
- Percentage of Sales – uses a percentage of the total sales for a particular period.
- Percentage of Accounts Receivable – uses a percentage of accounts receivable method.
How to Prevent Bad Debt Expense
Having bad debt can significantly negatively impact your business. It will hurt your business in terms of net income and long-term success. That’s why as early as now, you need to find a way to fix this issue. The longer it lingers, the worse it will become.
Fortunately, there are different ways of preventing bad debt. Here are three of the best methods:
Do Some Sleuthing
Whether you’re doing business with individual people or another business, it’s essential to know the financial health of your clients. You can partner with a credit reporting company to provide you with that information. It should also be mandatory and part of your onboarding strategy. Always remember that knowing who you’re doing business with is crucial. Do some research, speak with past suppliers or industry colleagues. Look at other stores that the customer has also purchased from. By doing all this, you can have a better picture of what you’re going to deal with later.
Add Upfront Payments to Your Business Policy
For your small business to thrive, you need to start taking partial upfront payment. You can start low, then take it up a notch by presenting a payment schedule on engagement. For example, you can start with 25% as upfront payment, then another 25% after hitting a key milestone in the projects. The remaining 50% will then be compensated upon completion.
By having upfront payment, you can reduce the amount that’s owed to you over time. That way, you won’t succumb to bad debt expense as you’ve already got the majority of costs. Sure, you’ll still lose a percentage of the profit. But at least it isn’t totally zero.
One way to entice customers to pay early or on time is to implement incentives. Within your payment terms, you should include a line that talks about incentivizing customers that pay early or on time. To ensure timely payments, you can offer small discounts.
Structure your payment terms to encourage on-time payments. It’s a far better approach than issuing penalties and late fees for overdue invoices. Plus, discounts also have a psychological effect on customers looking to save as much money as possible. Thus, they’ll be enticed with the discount.
Bad debt expense is bad for business. That’s why you should keep it at a minimum by acknowledging that it exists and doing something when you have it. Consider the steps and methods that we’ve discussed, and make sure you avoid bad debt expenses as much as you can.