Understanding Bad Debts
Upon hearing about bad debt expense, the first thought that might come to mind is, aren’t all debts bad? However, they are an essential part of business. If your receivables are paid on an agreed-upon time and with interest, that is an example of good debt.
However, if a customer cannot pay or has no intention of ever paying, that’s when debt becomes bad. To be more precise, bad debt is an irretrievable receivable. As a business owner, such situations can negatively impact your enterprise. If you want to better deal with bad debts, you need to understand them better.
Why Bad Debts Happen
Bad debts occur due to various reasons. One of them is when a company extends credit to a customer who cannot pay back what they owe. This might be the result of lax or bad internal processes in assessing a debtor’s ability to repay their debt. It can help to tighten up your existing credit policy to stop it from happening.
Another circumstance when bad debt occurs is when a customer intentionally targets your company for fraud. They misrepresent themselves on purpose while obtaining a sale on credit but have no intention of paying the seller. However, sometimes, the reason is simple: a debtor cannot pay their bill due to financial incapability or bankruptcy.
How To Record Bad Debt
There are two ways you can record bad debt:
- Direct Write-Off Method – This method is used when you have recognizable bad debt on your accounts. For example, you already know that the debt is irrecoverable. Debit the bad expense for the amount of the write-off or the reduction in the recorded amount of your asset. After that, credit the accounts receivable asset account for the same amount.
- Allowance Method – If you’re using the generally accepted accounting principles (GAAP) for your business, the direct write-off method is not the best approach. Consider the bad debt provision or allowance method, instead. You’ll charge an estimated amount of accounts receivable to bad debt expense before debiting the bad debt expense for the estimated amount of the write-off.
After that, you credit the same amount to the bad debt provision account. This method matches expected bad debts to revenues, which allows for a more accurate financial statement.
The Importance of Understanding Bad Debts
Running a thriving business includes facing difficulties from time to time. One of them is when customers who consistently pay their debts become non-payers in a short amount of time. Your company will be judged by prospective investors based on your financial statements. Bad debt can make your enterprise look like it isn’t doing well, even if it is.
By learning about how bad debts work and how to record them in your financial documents, you can prevent them from negatively impacting your business. Clearly specify them as “bad debts” in your records, so investors can see that your accounts are in great condition.
Enlist Help From Experienced Accountants
If you need help recording your doubtful accounts expense, we at Tostrud & Temp, S.C. in La Crosse, WI can provide you with the support you need from day one. Regardless of the size of your business, we offer quality business accounting services that can assist you in keeping your accounts organized, so you can focus on serving your customers.
When you choose us, we can assure you that we’ll properly manage and maintain your current and future financial goals. Our experienced CPAs will listen attentively to your unique needs to help you better. Give us a call today.