No one likes to think about bad debts, and indeed bad debts happening to them; however, the reality is they do happen, and frequently.
We categorise a bad debt as a debt that is no longer collectable, i.e., the debtor can’t fulfil their financial obligations, so the money owed will not be received.
This can have a significant impact on your business, so it’s essential that you have the right accounting practices in place to record such impacts to allow you to continue to forecast for the future confidently.
In this post, Direct Route Ltd looks at a bad debt expense and the impact of a company not paying their invoice on your business.
What are bad debt expenses?
If you extend credit to a business for goods and services, it is most likely that you will encounter bad debt expenses.
A bad debt is ultimately a loss; however, it is noted as an expense when recording this in your accounting.
It is the amount of money your business does not expect to collect for a number of reasons, ultimately reducing the receivables on your balance sheet.
Bad debts are unfortunate, and there are a number of reasons why a debt might become uncollectible, for example:
- The business has been declared bankrupt and can no longer pay its outstanding bills. Unfortunately, some creditors won’t be paid during this process.
- There is a disagreement between the client and the business, resulting in the customer withholding payment.
- Poor communication is another key area explaining why bad debt occurs. For example, no follow-ups once the invoice becomes overdue, no statement issued, payment terms are unclear, confusing, etc.
Bad debt expense definition
Any outstanding bill/invoice that has become uncollectible, for example, because of bankruptcy, where the debt incurred has been inevitable, will be considered as a bad debt expense and will be entered into accounting records as such.
Placed in the general or administration section of your income statement, bad debt expense in business must be recorded in the most appropriate way.
There are two main ways to calculate bad debt expenses:
Write-off method – in this instance, the late payment of an invoice or bad debt is written off completely as soon as it becomes uncollectible. This is the most simplistic of the two methods, however it must be noted that it can lead to balance sheet inaccuracies.
Within the accounting process, you will debit bad debt expenses and credit accounts receivable, which can be confusing, and you will be required to have firm evidence that your client is 100% not in a position to pay and that you have taken all reasonable steps to collect the outstanding amount.
It is also important to note that the write-off method is not allowed under GAAP (General Accepted Accounting Principles) guidelines, which advise matching expenses to the revenue connected to them within the same accounting period.
In addition, you can only write off immaterial amounts.
Allowance method – a little more complex but the most preferred method due to its accuracy, the allowance method is where the amount of bad debt is estimated, with the estimate continually revised over time.
Using the allowance method, you can account for anticipated losses throughout the accounting period, providing you with a more accurate view of your financial statements.
However, this approach is more labour-intensive and resource-heavy, and can have more calculation errors.
The calculation formula to estimate your allowance includes:
- Percentage of sales calculations
- Percentage of accounts receivable
- Aging accounts receivable.
What can you do when an invoice is not paid?
Overdue and late payments can significantly impact your revenue and cash flow, which in turn negatively affect business growth and further opportunities.
The good news is that there are strategies you can implement within your credit control processes to avoid these situations from occurring.
Be open and transparent in all your communications – set clear payment terms with information about what happens when a customer defaults on a payment.
Send reminders – and follow up. As soon as an invoice becomes overdue, it’s important that you follow this up via phone and get to the bottom of the reason why, and if this can be rectified.
Offer flexible payment options – offer a range of payment options and ways to pay, making it as easy as possible for your customers.
Have clear credit control processes – does your team know what to do and how to report bad debt expenses?
Work with a professional debt collection agency – tap into their skills and expertise in this area and use it to your advantage.
Company not paying invoice?
Let us help.
Use our years of experience and knowledge in collections to help you with your credit control processes, including collecting on those invoices not yet paid.
Bad debt must be recognised as it will and does have tax implications.
Limit your bad debt expenses today, call +44 7860 197 476 or email memberbenefits@directroute.co.uk and see how we can help.