Owning and operating a business means celebrating in its successes while also dealing with the not-so-successful outcomes. Owed debt, or bad debt expenses, is one of the many things your company must deal with as a price of offering credit. Losing money from a bad deal does not necessarily mean your business must pay the full cost of the debt.
From this article, you can learn what bad debt expense is, how to deal with it using the direct-write off or allowance methods, and how you can deduct such expenditures from your income taxes.
Bad Debt Expense Definition
Bad debt expense is money that is owed to you but cannot be collected or paid. Typically, this happens when a customer purchases your business’s goods or services on credit and cannot pay off the total credit amount. This type of expense is a contingency that all companies must account for when offering customers products or services on credit.
As dictated by the Canada Revenue Agency, this expense is categorized as a bad debt expense only after all means of collecting the credit have been exhausted.
What is a bad debt example?
Suppose you provide a $500 car detailing service to one of your customers, presenting them with a $500 invoice for the completed job. If the client goes bankrupt and cannot pay the invoice amount, and you have explored every avenue of obtaining the owed amount, only then can it be considered a $500 bad debt expense.
Bad debt as capital loss
For bad debt to be considered a capital loss by the CRA, it must have happened in one of two situations:
- You acquired bad debt to earn income from your business or property.
- You acquired bad debt as payment for the sale of capital property in an arm’s length transaction (a transaction referring to a business deal with both the buying and selling party acting independently of one another, without influence).
Direct Write-Off Method vs. Allowance Method
Your business will need to account for bad debt within its financial books and accounting records each accounting period. To do so, you will need to make a bad debt expense journal entry to your accounts.
Recording bad debt expense means debiting one account and crediting another for the same amount. This can be done in one of two ways using either the direct write-off or allowance accounting methods.
Direct write-off method
The direct write off method allows businesses to account for debt that cannot be collected or paid for by the customer at any time of the year. This uncollectible expense can be accounted for with one double journal entry.
Once your business decides that a bed debt is uncollectible, use this accounting method to debit Bad Debt Expense account or the uncollectible accounts, while crediting Accounts Receivable for the corresponding amount. This method works best for businesses that use cash basis accounting.
The allowance method deals with bad debt at the end of a tax year. The business must review its receivable accounts and estimate the cost of the uncollectible bad debt. At the end of the year, the estimated amount will be debited from the Bad Debt Expense account and credited to the contra account, referred to as the Allowance for Doubtful Accounts or allowance for bad debts.
An allowance for doubtful accounts should be created at the beginning of a year and is a set amount, one that you believe covers the anticipated debt losses each year. This allowance account is a permanent account that will appear on your business’s financial statements, specifically the balance sheet and income statement, and refers to the predicted and allocated amount already recorded in Accounts Receivables for bad debt.
As for the bad debts expense account, you will need to determine what percentage of invoices you expect will go unpaid for that year. Take into consideration the experiences you have had with your customer base and the credit policy of your company. Then, every time a sale occurs, a percentage of sales must be placed into the bad debts expense account. In contrast to the allowance for doubtful accounts, this account does not appear on the balance sheet line items and must be zeroed out at the end of the tax year.
If your business uses the accrual method of accounting and follows the International Financial Reporting Standards (IFRS), then the allowance method should be used by your company to write-off this type of expense.
This method allows companies to anticipate the amount of bad debt that might occur during business dealings throughout a given year, and choose to keep a debt reserve or reserve account in response.
Deducting Bad Debt From Your Taxes
For the CRA to consider bad debt as a deductible expense, you must have done one of two things:
- Determined that an account receivable is a bad debt in the specified tax year
- Have already included the receivable in income
After, you will be able to deduct bad debt expenses by claiming it as a business expense on your income tax return using Line 8590 of Form T2125, Statement of Business or Professional Activities. Remember that at this time, you could have already reported the unpaid invoice as income on your previous year’s tax return.
How to Calculate Bad Debt Expense
To accurately calculate bad debt expenses, you can use the basic accounting formula known as the bad debt expense formula which uses information from your receivables account. The amount of bad debt is divided by the total Accounts Receivable for the year and multiplied by 100, or:
Bad Debt Percentage = (uncollectible amount / Accounts receivable amount) x 100
Continuing the example from above, if that $500 unpaid invoice is a business’s only bad debt expense in the year, while their car detailing services netted their accounts receivable $10,000, then the formula would be as follows,
(500 / 10000) x 100 = 5%
From there, the business could decide to budget for next year’s bad debt expenses, projecting that 5% of their total sales could go unpaid, and account for that uncollected cost. Use these figures when developing a financial forecast for your business with the percentage of sales method.
Stop Bad Debt Before It Starts
Just because bad debt is a possibility when dealing with your customers does not mean you should stop extending credit. Especially if stopping the credit losses you more business in the long run. There are various ways you could mitigate the cost of unpaid invoices and owed debts.
Stop bad debt expenses before they start with invoice tracking to ensure your customers pay their bills accordingly. Your business might consider charging late fees for delinquent invoices or offer payment incentives in your payment terms. Perhaps check a customer’s credit balance before extending more. However, you won’t be able to mitigate every uncollectible expense, so it’s best to know how to deal with bad debt expenses using the appropriate accounting method.
Ensure your journal entries are accurate for your record-keeping purposes, with expense tracking and categorization. Using QuickBooks Online accounting software can help your business get hold of their bad debt expense. Why not try it free today.