One of the more unpleasant aspects of being a business owner is having to chase clients that do not pay. It is frustrating, stressful and disheartening, while attempts to collect are an unproductive use of time and can have a significant impact on cash flow, particularly if you are unprepared. A bad debt, in accounting terms, refers to an amount charged to a customer that is never paid. While the original sale would have been reflected as revenue, the uncollectible bad debt would then have to be written off as a separate line item on the profit and loss statement
A bad debt may occur for several reasons:
The customer has experienced financial difficulty or worse, they have filed for bankruptcy or creditor protection
Your client feels that the invoice amount is to high for the services rendered and therefore was only willing to pay a part of the invoice.
Your customer has become non responsive despite efforts to contact them and you feel that it is not longer worth trying to collect
There are ways to mitigate the possibility and impact of bad debts. Some of these include:
Performing a Credit Check on Customers to ensure that they pay their business and are not regularly delinquent
Charging a retainer, which is paid up front. This can be a fixed amount that is charged in advance of the product or service being provided.
Offering discounts for early payments
Allowing several payment options including credit cards which allows for immediate payments
Following up on delinquent receivables dilligently and regularly.
Regardless of your efforts to prevent them, incurring bad debts is usually inevitable and ultimately, a cost of doing business. Consequently, it is important to ensure that you are prepared.
Designate an Amount to reserve for bad debts (before you incur them):
Setting up a reserve for bad debts is an excellent way to prepare for them if and when they happen. It allows the business owner to show bad debts in small increments on their profit-loss and smooth out the effects rather than taking one big hit when they actually occur. In accounting parlance this is referred to as an Allowance for Doubtful Accounts (somewhat self explanatory) or AFDA. There are two ways to do this:
You can designate a percentage of your accounts receivable as uncollectible based on experience or the quality of your accounts receivable.
Periodically review your accounts receivable and specifically identify which amounts due might not be collectible. These can be enumerated in a schedule and written off right away or at the end of the year. The total of these amounts will represent your bad debts.
Set up a Reserve:
Once the amount of bad debts has been calculated, you should reflect it on your books. Since the bad debts are an expense it will reduce your net income for the period. The corresponding credit will be applied to a separate account called Allowance for Doubtful Accounts which reduces your accounts receivable.
what is the journal entry for a Bad Debt:
The journal entry for a specifically identified bad debt expense is:
Debit: Bad Debt Expense
Credit: Accounts receivable (for the specific customer for who the bad debt was incurred)
The journal entry for an allowance for bad debts is:
Debit: Bad Debt Expense
Credit: Provision or Allowance for Bad Debts (this is a negative or contra account that is shown right under the accounts receivable on your balance sheet)
The journal entry when you want to move a bad debt from the provision and take it off your accounts receivable listing:
Debit: Provision or Allowance for Bad Debts
Credit: Accounts receivable (for the specific customer for who the bad debt was incurred)
Since you have already set up the bad debt expense with the provision, it would only be a balance sheet entry.
How to Reflect AFDA and Bad Debts in Quickbooks desktop:
Set up a new Accounts Receivable accounts called Allowance for Doubtful Accounts (AFDA)
Set up a new expense account called Bad Debts expense
Set up a new Customer called AFDA
Setup a new item called Bad Debts and select Bad Debts expense as the account.
Create an invoice credit note for the estimated amount of the bad debts with AFDA as the customer and Bad Debts as the item.
When specific customers are deemed uncollectible, write off the amounts by creating a credit note for the specific customer and select bad debt expense.
Reduce your allowance either via a period end adjustment or create an invoice for the exact amount of the bad debt written off in #6 following the steps in #5. Since the bad debt has already been provided for, this will not impact on your bottom line
How to Reflect specific Bad Debts in Quickbooks online:
The initial entry in QBO when you make a sale to a customer would have been to record an invoice for the amount owing by the customer which would then be reflected on the accounts receivable report. In accounting parlance there would be a credit to sales and a debit to accounts receivable. Any payments would be offset against the invoice by “receiving payment” in the invoice module in QBO. To write off the full invoice or the balance of the amount owing for a customer:
Go to the + sign on the top left corner
Under customers select “credit memo”
Select the customer for whom you want to write off a balance
Select the date (note if you want to do it before a period or year end, then this date should be selected so that it is reflected on the profit loss)
Under “product/service”, type in “Bad Debt”. You will be prompted to create a new item. You can select non inventory product or service here.
Under “income account” you would add a new account called “Bad Debt” which is “expense” account. The detailed type is bad debts.
You can then add a sales tax code if you have the same sales tax code for all customers or leave it blank and enter it manually if your sales tax code varies by customer
All other fields are optional and can be completed if desired.
Once the product/service item and the chart of accounts account has been set up as Bad Debt, this will be available going forward for any future bad debts.
Enter the amount and sales tax code that applies to the specific customer.
You can then save and close.
Go to the profit-loss report and verify that the write off shows up in the bad debt section
Monitor your Reserves:
Depending on the size and number of accounts receivables, you should review your bad debt expense regularly. It helps to maintain a schedule which can be reviewed and updated.
Cash Flow and Tax Implications:
It is important to reflect a reserve for bad debts in your cash flow forecasts and budget. This will allow for you to contemplate other options in advance.
When specific bad debts are recorded in your books, make sure to reflect the sales tax impact. i.e. if your invoice included sales tax, make sure that it is reversed, so that you can recover sales taxes that were never actually received from your customer/client.
Reserves for bad debts (AFDA) are not tax deductible and need to be added back to net income when preparing your Federal tax return.(T2). It is only when specific invoices are written off that they become deductible.
In a perfect world customers would pay their debts on time. The unfortunate reality is that this does not always happen, for a variety of reasons, some uncontrollable. Ensuring that you are prepared can help reduce stress and lead to better business decisions .
Ronika Khanna is an accounting and finance professional who helps small businesses achieve their financial goals. She is the author of several books for small businesses and also provides financial consulting services.
Subscribe to our biweekly newsletter to receive articles, tips, tools and special offers for small businesses.
