When you sell a service or product, you expect your customers to fulfill their payment, even if it is a little past the invoice deadline. Unfortunately, it doesn’t always work out that way.
If your small business accepts credit sales, you run the risk of encountering something called a “bad debt expense.” Bad debt expenses are outstanding accounts that, after some time going unpaid, are deemed uncollectible.
In this post, we’ll further define bad debt expenses, show you how to calculate and record them, and more. Read on for a complete explanation or use the links below to navigate to the section that best applies to your situation.
- What is a bad debt expense?
- Why bad debts happen
- How to calculate the bad debt expense
- How to record the bad debt expense journal entry
- What is the bad debt expense allowance method? Establishing a bad debt reserve
- Preventing bad debts
A bad debt expense is a portion of accounts receivable that your business assumes you won’t ever collect. Also called doubtful debts, bad debt expenses are recorded as a negative transaction on your business’s financial statements.
Every business has its own process for classifying outstanding accounts as bad debts. In general, the longer a customer prolongs their payment, the more likely they are to become a doubtful account. When your business decides to give up on an outstanding invoice, the bad debt will need to be recorded as an expense. Bad debt expenses are usually categorized as operational costs and are found on a company’s income statement.
Recording uncollectible debts will help keep your books balanced and give you a more accurate view of your accounts receivable balance, net income, and cash flow.
We’ll show you how to record bad debt as a journal entry a little later on in this post.
If your business allows customers to pay with credit, you’ll likely run into uncollectible accounts at some point. At a basic level, bad debts happen because customers cannot or will not agree to pay an outstanding invoice. This could be due to financial hardships, such as a customer filing for bankruptcy. It can also occur if there’s a dispute over the delivery of your product or service.
For example, if you complete a printing order for a customer, and they don’t like how it turned out, they may refuse to pay. After trying to negotiate and seek payment, this credit balance may eventually turn into a bad debt.
Calculating your bad debts is an important part of business accounting principles. Not only does it parse out which invoices are collectible and uncollectible, but it also helps you generate accurate financial statements.
There are two ways you can calculate bad debt expenses for your business:
- Direct write-off method: If most of your customers fulfill their credit payments, and you don’t have many bad debts, you may decide to write them off individually. It may be time to write off bad debts after an invoice has long surpassed its deadline and you’ve taken several steps to try to collect the outstanding balance.
- Allowance method: Businesses that conduct most sales on credit are usually more likely to encounter bad debts. In this case, it may be helpful to plan ahead for uncollectible payments using the allowance method. Also called the allowance for doubtful accounts, this option preemptively labels a certain portion of your total credit sales as doubtful debts. This way, you can plan ahead for bad debts and budget accordingly.
To estimate bad debts using the allowance method, you can use the bad debt formula. The formula uses historical data from previous bad debts to calculate your percentage of bad debts based on your total credit sales in a given accounting period.
Percentage of bad debt = total bad debts/total credit sales
Now that you know how to calculate bad debts using the write-off and allowance methods, let’s take a look at how to record bad debts.
Recording bad debts is an important step in business bookkeeping and accounting. It’ll help keep your books balanced and give you realistic insight into your company’s accounts, allowing you to make better financial decisions. However, bad debt expenses only need to be recorded if you use accrual-based accounting. Most businesses use accrual accounting as it is recommended by Generally Accepted Accounting Principle (GAAP) standards.
Businesses that use cash accounting principles never recorded the amount as incoming revenue to begin with, so you wouldn’t need to undo expected revenue when an outstanding payment becomes bad debt. In other words, there is nothing to undo or balance as bad debt if your business uses cash-based accounting.
With that said, here’s how to record a bad debt as a journal entry:
- If you’re using the write-off method to report bad debts, you can simply debit the bad debt expense account and credit your accounts receivable.
- To use the allowance method, record bad debts as a contra asset account (an account that has a zero or negative balance) on your balance sheet. In this case, you would debit the bad debt expense and credit your allowance for bad debts.
Establishing an allowance for bad debts is a way to plan ahead for uncollectible accounts. By estimating the amount of bad debt you may encounter, you can budget some of your operational expenses, as an allowance account, to make up for some of your losses.
Setting this amount aside enables you and your accounting team to get a better view of what is actually going on with your finances, where your assets stand, and the amount of accounts receivables you actually plan to collect.
If your business extends credit options to your customers, you will likely have to deal with bad debts eventually. Luckily, there are a few things you can do to prevent bad debts from happening in the first place:
- Establish a clear credit policy with payment expectations.
- Implement early payment discounts or late payment fees to encourage timely payment.
- Send automated invoice reminders with QuickBooks to follow up on outstanding balances.
QuickBooks has a suite of customizable solutions to help your business streamline accounting. From insightful reporting to budgeting help and automated invoice processing, QuickBooks can help you get back to the daily tasks you love doing for your small business.
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