If you provide products or services before being paid, you are occasionally going to experience a bad debt. This occurs when you issue an invoice, but your client doesn’t pay it. There are two distinct ways of dealing with bad debts in your books, and it’s important to understand both of these strategies. In many cases, you may claim a deduction for bad debts on your tax return.
With the direct write-off method, you simply subtract bad debts from your accounts receivables. To illustrate, imagine you send an invoice to a client for $2,000. The client goes bankrupt and cannot pay. As a result, you subtract the invoiced amount from your accounts receivables.
This method is the simplest, and if you use cash basis accounting, you can use the direct write-off method while tracking outstanding invoices. However, if you use accrual accounting and want to be consistent with general accounting principles, you should use the allowance method to write off bad debts.
The allowance method allows you to anticipate bad debts before they occur. With this method, you may create an allowance for doubtful accounts or a bad debts expense account. The allowance for doubtful accounts is a set amount that you anticipate losing every year. It is a permanent account that appears on the balance sheet, and it refers to funds already recorded in accounts receivable that you anticipate turning into bad debts.
In contrast, the bad debts expense is an expense account. You identify the percentage of invoices you expect to not be paid, and every time you have a sale, a percentage of the sale amount is put into the bad debts expense account. This account does not appear on the balance sheet, and it gets zeroed out at the end of the year. However, using a bad debts expense account is a great way to peg potential bad debts to sales.
Recording Bad Debts With the Allowance Method
To explain the process, imagine you are a fruit vendor. You sell 15 baskets of bananas to a local health food shop and issue an invoice for $100. However, the store goes out of business and doesn’t pay the invoice.
You have already recorded the $100 in your accounts receivable, and you need to eliminate that amount. As you use double-entry accounting, you must record a $100 credit to your accounts receivable and a $100 debit to your allowance for doubtful accounts or your bad debts expense column.
As your accounts receivable are recorded as debits, the credit lowers the balance in this category. That reflects the fact that you now have a lower amount of outstanding invoices. Adding the debit to the other column keeps the books balanced by maintaining the net value of these two accounts.
If you have a bad debt, you may claim it as a business expense on line 8590 of Form T2125. To claim this deduction, you may have already reported the unpaid invoice as income on a previous year’s return.