Endlessly waiting on a customer to pay an invoice, but getting no response? Then it is time to throw it out and write it off as a bad debt expense. Having money tied up in accounts receivable messes with the clarity of your business performance. Treat bad business debt the right way, with this how-to.
In this article:
- What is a bad debt expense?
- IRS provision for credit losses
- Business debt vs nonbusiness debt
- Direct write off method vs allowance method
- The bad debt and bad debt reserve formula
- 7 ways to prevent bad debt
What Is A Bad Debt Expense?
Bad debt is when a customer doesn’t pay you for your goods/service. It occurs when you offer sales on credit, held in accounts receivable. After multiple attempts to collect, when the client is unable or unwilling to repay the invoice, it becomes worthless bad debt. When a business accumulates bad debt they will move it out of accounts receivable as a bad debt expense.
Bad Debt Expense AKA
- Doubtful Debt Expense
- Bad Debt Write-off
- Provision for Credit Losses
Bad Debt Expense In Cash vs Accrual Accounting
This is an accounting event specific to the accrual method. In accrual accounting, you report revenue as it is earned, under cash-basis accounting, money is recorded as it changes hands. So extending credit to someone isn’t reported as revenue under the cash method. This doesn’t mean bad debt doesn’t happen, only that it isn’t a deductible expense recorded in the books.
For Example: You performed $2500 worth of business consulting services to a startup, but they have yet to pay you. Your business runs on cash accounting so you cannot deduct an IOU from your income because it was never recorded as income. Unfortunately, you are out on the money.
For accurate reporting in accrual accounting, bad debt needs to be written off the books. Holding it in accounts receivable for more than 90 days poses a risk to the accuracy of your accounting. The longer the invoice goes unpaid the more likely it will be uncollectible. Accumulating bad debt can lead to overstating your revenue and asset accounts, along with any interest income linked to those accounts.
Bad Debt Write-off For Tax Purposes
Under accrual accounting, you report income as it is earned to the IRS. Regardless of whether you actually received money, on your taxes, it shows it as received revenue. Keeping doubtful debt in accounts receivable will appear as overstated income which means higher tax liability.
IRS Provision For Credit Losses
To remove doubtful debt from your books, first, you have to ensure that it is uncollectible. The process of deeming doubtful debt as uncollectible needs to comply with IRS provisions.
A company needs to prove that business deliverables were met and the debt has no chance of repayment. You cannot write off bad business as bad debt, you need to show you met the requirements of the initial contract, and the client has repeatedly avoided repayment. Having a receipt as proof that you upheld your end of the bargain, and you made every attempt to collect any outstanding payment is credible evidence to the IRS.
A debt becomes worthless when there is no longer any chance the amount owed will be paid. This may occur on the date the debt is due or prior to that date…To demonstrate worthlessness, you must only show that you have taken reasonable steps to collect the debt but were unable to do so. It isn’t necessary to go to court if you can show that a judgment from the court would be uncollectible—IRS Publication 535
It is good practice to keep notes of your attempts to collect payment. Every attempt to collect should be noted in your accounting system: calling, messaging, offering negotiable terms, extending payment deadlines, and any conversations with the client. This process validates the debt as uncollectible, in case you are subject to an audit.
After the debt is deemed worthless, the amount can be deducted to the extent that it was reported as income. This should be a given, but you cannot deduct more than what was initially reported. Although, when invoices have longer payment terms, spanning over multiple years, you can write off portions as they become worthless to normalize income over the years.
Business Bad Debt vs Nonbusiness Bad Debt
On top of deeming your doubtful debt uncollectible, you need to have proof that it is business-related. Business bad debt means that the loss was accrued concerning your business or trade, with enforceable payment terms. Nonbusiness bad debt means it was done as a personal favor, or as an effort to contribute to capital. In that event, it can only be deducted as a capital loss, and the deduction can’t exceed $3000.
Types Of Business Bad Debt
Bad debt comes in different forms depending on the type of business. The Golden Rule—if it was previously included as income then it can be expensed as bad debt. The following are examples of business bad debts:
- Credit sales to customers
- Loans to clients, suppliers, distributors, and/or employees
- Business guarantees like a company credit card for an employee
How To Calculate A Bad Debt Expense
Typically at the end of the financial period, a business will calculate its total bad debt. Then it will be expensed into a contra account against accounts receivable. At the end of the year, the balance of the bad debt expense account will be deducted from taxes.
Direct Write-off Method vs Allowance Method
There are 2 ways to calculate bad debt: the direct write-off method vs the allowance method. The direct write off method allows you to write off bad invoices as they occur. This is used by most small businesses, who have a few dead invoices and want to perform write-offs exactly. The drawback to the direct write off method, it is not in compliance with GAAP principles. It doesn’t follow the matching principle in accrual accounting, which states that an expense needs to be reported in the same period as the transaction occurs.
Bad Debt Allowance AKA
- Allowance for Bad Debts
- Allowance for Doubtful Debt
- Bad Debt Reserve
- Bad Debt Provision
For publicly traded companies following GAAP, or a high volume of sales on credit, the allowance method is used. The allowance method is like a savings account that you give an annual allowance, based on a percentage of sales or accounts receivables determined to be bad debt. Monthly you calculate your bad debt expense using the bad debt formula. Instead of accounts receivable being expensed, your allowance account is credited.
Calculating Bad Debt Formula
At the year-end you will use the bad debt expense formula to calculate your percentage of bad debt. This is to fill your allowance for doubtful accounts for the next year. To do this you will need a couple of items: this year’s sales and bad debt, and next year’s projected sales.
For Example: A tech security company did $100,000 in sales this year, and $7,000 was deemed uncollectible. Next year they anticipate doing $250,000 in sales.
Bad Debt Expense Formula
% of Bad Debt = (Total Bad Debt / Total Credit Sales) x 100
Bad Debt Reserve Formula
Bad Debt Reserve = (% of Bad Debt) x (Projected Credit Sales)
Using the bad debt expense formula we can find out how much doubtful debt the tech company had this year.
% of Bad Debt = (Total Bad Debts / Total Credit Sales) x 100
% of Bad Debt = ($7,000/$100,000) x 100
% of Bad Debt = 7%
Based on this year’s numbers, the tech company should create a bad debt reserve equal to 7% of sales in the next year.
Bad Debt Reserve = (% of Bad Debt) x (Projected Sales)
Bad Debt Reserve = 7% x $250,000
Bad Debt Reserve = $17,500
The tech company should allow for $17,500 in bad debt for next year.
The Aging Method
The aging method is a granulated calculation for a bad debt allowance, using accounts receivables. Large companies, with a lengthy sales history, use this method because it is a more realistic percentage of bad debt. Instead of doing one calculation for the entirety of sales, you age your accounts receivables.
With the aging method you organize accounts receivable into different time windows according to your payment terms—30 days, 60 days, and 90 days. Divvy up the invoices and allow an increased percentage of bad debt for each time window. Next, you calculate the allowance needed based on these percentages.
For Example: A tech security company found they have 1% of doubtful debt in 30 days, 5% in 60 days, and 15% in 90 days. Next year they anticipate doing $250,000 in accounts receivable, with $225,000 paid in 30 days, $15,000 in 60 days and $10,000 in 90 days.
Bad Debt Reserve = (% of Bad Debt x Projected Sales 30-day) + (% of Bad Debt x Projected Sales 60-day) + (% of Bad Debt x Projected Sales 90-Day)
Bad Debt Reserve = (.01 x $225,000) + (.05 x $15,000) + (.15 x $10,000)
Bad Debt Reserve = $2,250 + $750 + $1500
Bad Debt Reserve = $450
Bad Debt Expense Journal Entry
Making a bad debt expense journal entry is an adjustment to your accounting for doubtful debt. Whether you use the direct write-off method vs the allowance method, the journal entry is the same. You are putting doubtful debt into an accounts receivable contra account, to document that it is no longer income.
Here is how to make a direct write off method journal entry:
For Example: A tech security company has 2 bad debt invoices for a total of $1250 they want to write off.
Under the direct write off method, you need to take the sum of uncollected invoices directly out of accounts receivable. So you debit the bad debt expense account $1250; and credit accounts receivable $1250.
Here is how to make an allowance method journal entry:
For Example: A tech security company made $20,800 in sales for the month and has a 7% bad debt allowance.
Under the allowance method, you calculate the bad debt expense for the month, it is roughly $1500. This is a debit to the bad debt expense account for $1500, and a credit to your allowance account for $1500. At the end of the year, you will debit the balance of your bad debt expense from your accounts receivable.
7 Ways To Prevent Bad Debt
There are ways to mitigate bad debt so you don’t lose out on money. Here are 7 ways to prevent bad debt expenses:
- Have a clear credit policy and payment expectations for your customers.
- Implement late fees or interest charges.
- Set automated payment reminders for your clients to encourage on-time payments.
- Add credit ratings to your client accounts based on their payment history. This allows you to offer precise payment timeframes for sales on credit.
- In Xero you have the option of looking up a company’s credit score. Do this before approving the first sale with a client, to be sure they are reliable.
- Set up a rewards system with a kickback for your clients when they pay early or on time.
- Get credit insurance or work with a collections agency as a safeguard. That way bad debt expenses do not interfere with your ability to fund daily operations.
Take Out Bad Debt Expenses
Bad debt in your accounts receivable hurts your bottom line. Not only does it skew income reporting, but it is also money that you won’t be earning. Taking it off the books will ensure that your reporting is accurate and you aren’t paying taxes on revenue you never received. Minimizing doubtful debt with our techniques will increase your credit sales and keep your customers happy.