Extending credit to customers is a great way to encourage impromptu purchases, boost sales, and increase profits. But sometimes, customers don’t pay you, resulting in a bad debt. What is bad debt?
What is bad debt?
A bad debt occurs when someone owes you money but you are unable to collect it. The debt is worthless because you cannot collect what you are owed. As a result, you write off the debt as uncollectible. For most small businesses, this happens when you extend credit to customers.
Let’s say you make a sale to a customer worth $800. The customer uses store credit and receives your business product upfront. After invoicing the customer repeatedly without success, you realize their debt has become a bad debt.
Creditors can also incur bad debts on account of you. If you don’t pay for items you’ve purchased on credit, your vendor will be faced with a bad debt.
Bad debts can happen for a number of different reasons. Customers might not have the money to pay their debt. Or, a customer might be unhappy with your product or service and refuse to pay. Regardless of the reason, too many bad debts can cripple a small business.
Bad debt vs. doubtful debt
If you deal with bad debt, you should also understand doubtful debt. Do not confuse the two terms.
Doubtful debt is money that you think will turn into bad debt, but it isn’t officially marked as uncollectible. There’s hope that doubtful debt will turn into a payment, unlike bad debt.
Businesses can label a certain number of their sales on credit as doubtful debt so their finances don’t take a major hit when a customer won’t pay. Instead, the business predicts that some debts will go unpaid.
When does debt become a business bad debt?
Knowing when to call a debt a bad debt can be difficult. There isn’t a switch that immediately changes it. However, here are a couple ways you can tell if you are faced with a bad debt.
A debt might become a bad debt if you have exhausted all options to get the customer to pay. For example, you may have attempted to contact the customer with no response. Or, you might have offered to negotiate payment terms. Keep in mind that you must follow debt collection rules, established by the FTC, to collect the debt.
If you decide that the debt isn’t worth pursuing, you might write it off as a bad debt. Then, you will need to update your accounting records to reflect the transition of a debt to a bad debt.
Bad debts accounting
Bad debts take place in double-entry accounting.
When you make a sale to a customer who pays with credit, you must debit your accounts receivable account and credit your inventory account. You hope to eventually credit the accounts receivable account and debit your cash account, but you can’t do that if a customer doesn’t pay.
Instead, you need to know how to write off bad debt. There are two methods you can use so your accounting books reflect a bad debt expense.
Many businesses set up a bad debt reserve, which is known as an allowance for doubtful accounts. The goal of this account is to offset the planned or anticipated loss incurred by bad debts.
Other businesses simply reverse their original entry by crediting their accounts receivable account and debiting their bad debts expense account.
In some cases, bad debts can be collected. If you hire a collection agency to pursue a customer’s payment, you might eventually receive money that you had written off as bad debt. In this situation, you will need to reverse the bad debt journal entry.
Bad debts and tax returns
If you have a bad debt that was previously included in your gross income, you can claim it with the IRS to reduce your business’s tax liability.
Updating your accounting books to reflect bad debts can be time consuming and confusing. Patriot’s online accounting software helps simplify the recordkeeping process. Update your books in minimal time, with access to free, U.S.-based support. Get your free trial today!
This article has been updated from its original publication date of 11/19/2014.
This is not intended as legal advice; for more information, please click here.