Managing bad debt is a crucial aspect of running a successful business, especially in uncertain economic times. When clients don’t pay their invoices, those unpaid amounts eventually become bad debt expenses that are unlikely to be recovered. High levels of bad debt can jeopardize your cash flow and, in extreme cases, threaten the viability of your business. To protect your financial health, it’s essential to understand how to accurately calculate, track, and improve your approach to bad debt. Keep reading to discover:
What is Bad Debt Expense?
Why is Tracking Bad Debt Expense Important?
How to Calculate Bad Debt Expense?
How to Record Bad Debt Expenses?
How to Improve your Accounts Receivable to Avoid Bad Debt?
Pssst! Upflow allows you to automate your receivable process to get paid more easily and faster. Eliminate your bad debt and focus on planning for your growth instead.
What is Bad Debt Expense?
Bad debt expense is the accounting entry businesses use to anticipate potential bad debts in the future. This estimate reflects the amount of receivables expected to go uncollected over a specific period and is recorded as an expense on the income statement.
While bad debt expense prepares a business for potential losses, actual bad debt occurs when invoices remain unpaid. In these cases, the services or products have been delivered, the invoices sent, but the payment never arrives. After some time, the invoice is deemed uncollectible and written off as bad debt. These uncollected amounts are often referred to as doubtful debts or doubtful accounts, as the business doubts the likelihood of ever receiving payment.
Bad debt commonly arises in situations where businesses offer credit terms, such as Net 15 or Net 30 payments, and the client either cannot or chooses not to pay the invoice.
Why is Tracking Bad Debt Expense Important?
Tracking bad debt expense is crucial for several reasons:
Accurate Financial Reporting: Bad debt expense ensures that your financial statements reflect the true profitability of your business. By accounting for potential losses from uncollectible receivables, the income statement provides a more accurate picture of your company’s financial health.
Cash Flow and Liquidity Management: Bad debt can threaten your company’s liquidity. It represents money from sales that you planned to receive but never did, which can strain your cash flow. Tracking bad debt expense ensures that your liquidity and overall sustainability aren’t challenged, helping you keep your business afloat.
Risk Management and Process Optimization: Monitoring bad debt expense allows you to assess the success of your accounts receivable process. Optimized billing and invoicing can reduce the occurrence of bad debts. If you've accumulated significant bad debt, it may be a signal to review and improve your receivables process to mitigate future risks.
Budgeting and Forecasting: Tracking bad debt expense helps businesses forecast future revenue more accurately by accounting for potential uncollectibles. This aids in better budgeting and strategic planning, preventing overestimation of income and ensuring more stable financial operations.
Balancing the Books and Tax Benefits: Bad debt is recorded as an expense in your general ledger and appears as an operational cost on your income statement. This means you won’t pay taxes on income you never earned, providing some relief in your tax obligations. Tracking bad debt helps you balance your books and ensures that your financial reporting remains compliant.
By consistently tracking bad debt expense, you not only protect your cash flow and liquidity but also optimize your receivables process, ensuring a healthier financial future for your business.
How to Calculate Bad Debt Expense?
There are two primary methods for calculating bad debt expense: the Direct Write-Off method and the Allowance method.
1. The Direct Write-off Method
The write-off method is the most straightforward way to calculate and report your bad debt. It means simply manually recording your bad debt as an expense, as they occur.
At the end of the year, you calculate how much bad debt you wrote off - that’s it! You can compare your total with the previous years and see if there is a variation.
It’s best used if a few bad debts occur in your business, as manually processing those can take some time. As a small business, you might want to consider this option if you don’t do a lot of credit sales.
2. The Allowance Method
For businesses that frequently engage in credit sales or regularly write off bad debts, the Allowance Method is more appropriate. This method involves creating a Bad Debt Reserve by estimating and setting aside a percentage of total credit sales as a buffer for potential bad debts. This estimation aligns with the matching principle, recording bad debt expense in the same accounting period as the related credit sales, which helps balance the liabilities on the balance sheet. There are 2 bad debt expense formulas under the allowance method
Percentage of Bad Debt:
To calculate your allowance, you first need to calculate your bad debt rate, which is based on your past experiences.The percentage of bad debt formula:
% of Bad Debt = Total Bad Debts / Total Credit Sales (or Total Accounts Receivable).
Once you have your result, you can project it onto your current credit sales. So if your bad debt rate was 2%, you can move 2% of your current credit sales into your bad debt allowance. We’ll see later how exactly to report that.
The Account Receivable Aging Method:
Another way to know how much to plan for your bad debt reserve is to use the aging method.
To do so, you need to have your aging report at hand. They show you where your invoices stand in different categories:
0 to 30 days overdue,
31 to 60 days,
61 to 90 days,
etc.
It’s a great way to visualize where your accounts receivable are piling up. You can then attribute a percentage of bad debt to each of these categories.
As a rule, the longer it hasn’t been paid, the slimmer the chances of an invoice ever getting paid. For example, you’d put 1% bad debt to your 0 to 30 days category, and 30% past 90 days.
Calculate what amount of your accounts receivable it represents in each category and add them to get your total bad debts. That’s your projected bad debt, whose amount you can now allocate to your allowance account.
How to Record Bad Debt Expenses?
Now that you know how to calculate bad debt expense, it is important for you to understand, When does an account receivable turn into bad debt? There are several elements to this question:
Bad debt only happens in accrual accounting.
Based on the GAAP (Generally Accepted Account Principles), accrual accounting records transactions when they are rendered.
If your client agrees to an invoice, it is recorded by your company right away as an income - regardless of whether it has actually been paid or not.
When an invoice needs to be written off, it, therefore, has to come off as an expense on your financial statements to be accurate.
In cash-based accounting (the opposite of accrual accounting), transactions are recorded when cash leaves or lands on your company’s accounts. So when an invoice isn’t paid, there is nothing to record or undo. Technically, nothing ever happened.
What the IRS says on bad debt.
According to the IRS, an unpaid invoice can only be written off as a bad debt when there isn't a chance the amount due will be paid. In order to do that, you have to be able to demonstrate you’ve taken reasonable steps to collect the debt.
That’s why payment reminders are key in your account receivable process and especially in recognizing bad debts.
When to record bad debt for your business.
Practically, you are the one who decides when exactly to record bad debt in your business. Depending on your main sales method (cash or credit) and credit policy, a different timing will make sense. Do remember the matching principle if you are using the allowance method.
Recording Bad Debt Using the Write-Off Method.
To record bad debt using the write-off method, you simply have to make a journal entry on your balance sheet.
Record:
A debit from your bad debt expense account.
A credit to your accounts receivable.
While this method records the precise amount that needs to be written off, it doesn’t respect the matching principles of the GAAP.
Recording Bad Debt Using the Allowance Method.
If you want to use the allowance method, you have to record your bad debt differently. For this, you’ll use a contra asset account to use as an account allowance for doubtful accounts.
This account is linked to your accounts receivable account on your balance sheet - it’s part of your liabilities. It also includes a third line that reflects the net amount you hope to collect.
To record your bad debts, you debit the bad debt expense account and credit your allowance for the bad debts account.
Let’s say that based on your projected amount of bad debt, you want to allocate $10,000 to your allowance account. It will look like this:
Now let’s imagine that sometime later, a client tells you they won’t be able to pay the $2,000 they owe you. You’ve offered solutions, even a repayment plan, but they won’t budge. So you decide to write their invoice off your accounts receivable.
Since you have an allowance account, you’ll be able to absorb this loss, but you need to record this as bad debt. Your journal entry will look like this:
How to Improve your Accounts Receivable to Avoid Bad Debt?
Now that you understand bad debt and how to account for it, let's focus on how to minimize it. The key lies in being proactive with your accounts receivable management.
1. Optimize Your Payment Process
Streamlining your payment process involves enhancing your billing, invoicing, and receivables procedures. Here are some actionable steps to make this happen:
Establish Clear Payment and Credit Policies: Define specific payment terms for different client segments, whether for small businesses or corporate accounts. Collaborate with your sales team to align on these terms, ensuring that all parties are on the same page. If necessary, implement an approval process where account managers need validation before agreeing to non-standard payment terms.
Simplify Payment for Clients: Make it as easy as possible for clients to pay you. This includes:
Sending invoices promptly with all relevant details, including clear payment terms.
Offering multiple payment methods, such as bank transfers, credit card payments, and links with payment instructions.
Ensuring a seamless payment experience by using user-friendly accounts receivable software, so clients can settle their invoices in minutes.
Now you know all about bad debt and how to record it, let’s look at ways you can minimize it. In a nutshell, it’s all about being proactive about your accounts receivable.
2. Be Proactive with Late Invoices
Preventing bad debt starts with proactive management of late invoices. This means taking action before and after an invoice becomes overdue:
Set Up Receivables Processes: Develop internal processes that make managing accounts receivable efficient and consistent. Consider:
Setting up regular reminders to follow up on unpaid invoices.
Assigning specific tasks to team members, so everyone knows their role.
Holding regular check-ins to assess progress and address any challenges.
When the entire team understands what needs to be done, and when, the process of managing overdue invoices runs smoothly.
Send Payment Reminders: Sometimes, clients simply forget to pay. To counter this, send reminders via email, SMS, or even phone calls. Following up with clients emphasizes the importance of payment, making it a priority for them as well.
At Upflow, we recommend automating repetitive tasks like sending reminders. Our A/R tool allows you to send automated and personalized payment reminder emails to customers. You can even create custom workflows tailored to different customer segments, ensuring effective follow-up for all types of clients.
Need help sending effective email reminders? Have a look at our free templates!
3. Leverage Automation to Improve A/R Management
Many tasks related to accounts receivable management, such as sending follow-up emails, checking invoice amounts, and tracking KPIs, can be repetitive and time-consuming. Automation helps streamline these processes, allowing you to focus on what matters most: preventing bad debt.
Automation can help you:
Enhance Efficiency: By automating tasks like reminders, tracking balances, and ensuring payment terms are met, you free up time to focus on accounts that need the most attention.
Facilitate Client Communication: Upflow’s tools make it easier for clients to communicate with you, such as raising invoice disputes directly through their dashboard.
Improve Financial Reporting: With advanced analytics, automation tools like Upflow help you manage A/R efficiently and make informed decisions to steer your business in the right direction.
By taking a proactive, structured approach to your accounts receivable automation, you can significantly reduce the risk of bad debt, improve cash flow, and enhance your company’s financial health.
Key Takeaways:
Bad debt expense is an accounting write-off of unpaid invoices. It’s an assumption that these invoices will never get paid, and falls under the operational costs of running a business.
It’s important to calculate your bad debt because it endangers your liquidity. Ultimately, if too many clients don’t pay, it jeopardizes your business.
How to Calculate Bad Debt Expense? There are several ways or formulas to calculate bad debt expense. You can sum up the manual write-offs you did during an accounting period, or use projected models like the bad debt rate and the aging method.
In order to be compliant with the GAAP, you need to report your bad debt using the allowance method. It is a projection of your possible bad debt amount that is allocated to a specific account. It will help buffer any future loss.
To prevent bad debt from happening in the first place, you need to be proactive in your accounts receivable process. You can do so by optimizing your payment processes, sending payment reminders, and using automation.
Upflow is an A/R software that helps you prevent bad debt. It allows you to be more efficient in your collectible process, so you can focus on the accounts and tasks that matter most.
