WHAT IS BAD DEBT?
What is a bad debt? It is simply credit that you’ve extended (i.e. your accounts receivables) that you can no longer collect on. Whether it’s the full amount or just part of what’s owed to you, if it’s uncollectible then it’s bad debt.
BAD DEBT MEANING
Bad debt can occur in any instance where you’ve extended credit to a customer. If repayment doesn’t occur, then that credit turns into bad debt. If you extend credit, you must be prepared for the risk of bad debt. Anyone who lends money or extends credit can have bad debt, not just banks or commercial lenders. If they extend credit to their customers, bad debt can happen to vendors and suppliers as well.
There are several reasons why a debt may become bad. It could be due to the customer in question being put into liquidation or their financial circumstances changing. They might also have obtained the credit from you dishonestly, with the intention of never paying the account. This is fraudulent behaviour.
Another reason why bad debt can occur is if a business didn’t do a proper bad debt risk assessment and extended credit to an unsuitable customer. In instances like these, the business needs to review the amount of money it is lending via the extension of credit and whether it has proper credit risk assessment processes in place.
GOOD DEBT VS BAD DEBT
Debt is a normal part of business. For many businesses, growth necessitates taking on some debt. Borrowing that helps to increase sales and has a positive impact on your bottom-line can be considered good debt. In contrast, bad debt has a negative impact on your financial statements.
HOW TO RECORD BAD DEBT
Accounting for bad debt can be done in two ways. The first is the direct write-off method. The second is the allowance method.
Bad debt write-off method
Directly writing-off bad debt is most common among small businesses. Using this method, a business writes-off bad debt as it occurs. Accounting for bad debt in this manner is precise in that it records the exact amount of bad debt incurred. The downside of this method is that it doesn’t adhere to the matching principle of accounting as per the generally accepted accounting principles (GAAP). If your business adheres to the GAAP or uses the accrual basis of accounting, then you’ll need to use the allowance method (also known as bad debt provision method).
Bad debt allowance method
Larger businesses tend to use the bad debt allowance or bad debt provision method (also known as provision for doubtful debts). This method does adhere to the GAAP. Using this method, businesses acknowledge that bad debt is a part of doing business and as such, estimate how much bad debt they’ll need to write-off over a given period. Under this method, write-offs must be recorded in the same period that the associated revenue is recorded. This is the reason why estimates are required, as debt often isn’t acknowledged as bad debt until some time has passed.
HOW TO ESTIMATE BAD DEBT
As with accounting for bad debt, there are different ways to estimate bad debt. To estimate bad debt, you can use the accounts receivable aging method or the percentage of sales method.
Accounts receivable ageing method
This method of estimating bad debt considers that as a debt ages, it’s more likely to go unpaid. Using this method, a business estimates the likely percentage of unpaid debt based on age of debt, for example 0-30 days, 31-60 days, 60+days. Each of these time periods has an estimated proportion of debt that will go unpaid. The percentage will increase for each bucket, reflecting the likelihood that unpaid bills will become more uncollectible as time goes on. For example, you might estimate that 1% of debts will go unpaid in the <30 days bucket, but that by the time you get to 60+ days, that figure might be more like 20%.
For an example of how to use the accounts receivable ageing method, let’s say a company had total accounts receivable of $120,000. $90,000 of this is in the 0-30 days bucket, $25,000 is in the 31-60 days bucket and the remaining $5,000 is in 60+ days. Using historical data, the company estimates that 3% of the debt in the 0-30 days bucket will be bad debt, 8% of the debt in the 31-60 days bucket and 23% in the 60+ days bucket. Using the accounts receivable ageing method, the company would then estimate a bad debt amount of $5,850.
Percentage of sales method
This method takes a more broad-brush approach and estimates bad debt based on the total amount of sales for a given period. When using this method of financial accounting, a business uses historical data to estimate the total amount of bad debt as a percentage of net sales. The resulting figure is then reported as a bad debt expense and at the same time, establishes an allowance for doubtful accounts of that same amount.
For example, let’s say a company had net sales of $120,000 for the period in question. That same company expects, based on historical accounts receivable data, that 6% of net sales are uncollectible. The company would then calculate that $7,200 worth of its accounts receivable would end up as bad debt. They’d then establish an allowance of $7,200 for doubtful debt and at the same time would report $7,200 as a bad debt expense.
As with all estimates, you might need to make changes down the track. This could be due to you collecting more than you’d estimated you would (i.e. you had a lower percentage of bad debt than estimated) or because unfortunately a higher percentage of debt was bad, and you need to increase the allowance for bad debt. This is done through an adjustment to your allowance for doubtful debt.
GETTING HELP WITH BAD DEBT
Dealing with bad debt can be stressful. One of the best ways to deal with it, is prevention. This isn’t always possible, but with proper credit control processes you can minimise the percentage of debt that you’ll have to write-off. CreditorWatch Collect helps businesses automate their collections process from sending a pre-reminder (yes, some people pay early) through to email and SMS reminder messages and a call queue assistant to make those chasing phone calls as efficient and effective as possible. If you’d like help getting your balance sheet healthy, get in touch with our team to learn more about how we can help improve your cash flow and keep bad debt under control.
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