Controlling bad debt is an essential element of running a successful company, especially during uncertain economic conditions. If customers don’t pay their invoices, the not-paid amounts will eventually turn into bad debt, which is unlikely to be paid back. High levels of bad debt could impede the flow of cash and in some situations, threaten the viability of your company. To ensure your financial security it’s crucial to learn how to precisely calculate your debt, monitor, and improve your strategy for dealing with bad debt. Continue reading to learn:
- What is Bad Debt Expense?
- Why is Tracking Bad Debt Expense Important?
- How to Calculate Bad Debt Expenses?
- How to Record Bad Debt Expenses?
- How can you improve your Receivables to avoid bad Credit?
Pssst! Upflow lets you automate your receivables processes to be paid faster and quicker. Get rid of bad debt and concentrate on planning your future growth instead.
What is Bad Debt Expense?
The expense of bad debt is the accounting method used by businesses to foresee potential bad debts in the near future. This figure reflects the quantity of receivables that are expected to be uncollected during the course of a certain time period. It is reported as a charge in the financial statement.
Although bad debt expense can prepare an organization for the possibility of loss, actual bad debt is when invoices are not paid. In these instances, the goods or services were delivered, and the invoices were sent, but the payment has not arrived. After some time, the invoice was considered not collectible and was written off as a bad debt. The uncollected amount is often called doubtful debts or accounts since the business does not believe that it is likely to ever receive a payment.
The most common cause of bad debt is circumstances where businesses provide credit terms, like Net 15, or Net 30 payments and the customer is unable to or is unwilling to make the payment.
Why is Tracking Bad Debt Expense Important?
The tracking of bad debt expenses is essential for many reasons:
- Correct Financial Reporting: The expense of bad debt assures that your financial statements accurately reflect the value of your business. In accounting for the potential loss due to uncollectible receivables income statement gives an improved picture of your company’s financial condition.
- Cash Flow and Liquidity Management: A bad debt situation could threaten the liquidity of your business. It’s the money you earned from sales you had planned to get but didn’t and can affect the liquidity. Monitoring bad debt expenses ensures the liquidity of your business and sustainableness aren’t compromised which helps you keep your business on the right track.
- Risk management and process optimization: Monitoring the cost of bad debts will allow you to evaluate the effectiveness of your process for obtaining accounts receivable. Invoicing and billing that is optimized can help reduce the chance in the form of bad debts. If you’ve accrued a significant amount of negative debts, this might be a sign to rethink and improve the process for receivables to limit future risks.
- Planning and Budgeting: Tracking bad debt costs helps companies predict future revenues more accurately as it accounts for the possibility of uncollectible debt. This assists in a better budgeting process and planning for strategic purposes, stopping underestimating income and guaranteeing more stable financial operations.
- Balancing the books and tax benefits: The bad debt is included in the general ledger as an expenditure. It appears as an operational expense when you look at your financial statements. This means that you will not pay tax on earnings you didn’t earn and can provide some relief from tax obligations. Monitoring bad debts helps to balance your books and also assures that your financial reporting complies.
If you are able to track every cost of bad debt by tracking bad debt expense, you can not only secure your cash flow and liquidity but also improve the process of receivables and ensure a better business’s financial future.
How to Calculate Bad Debt Expenses?
How to calculate bad debt expense There are two principal methods to calculate bad debt expenses including one method is the direct write-off method as well as the allowance method.
1. The Direct Write-off Method
The write-off approach is the easiest method to determine and record your debts. This means that you simply record any bad debts as a cost when they happen.
After the year you will calculate the amount of bad debt you paid That’s all there is to it! You can then compare your results against the prior years to determine if there’s an increase or decrease.
It’s best to use it when a couple of bad debts are incurred within your business since the process of manually processing them could take a while. If you’re a small-sized business you may want to think about this if you don’t make lots of credit sales.
2. The Allowance Method
For companies that often make credit sales or erase bad debts an Allowance Method is the best choice. This method requires the creation of the Good Debt Reserve by estimating and putting aside a portion of the total credit sales to be used as a buffer to protect against potential bad debts. This estimate is in line closely with that of the concept of matching that records bad debt expense within the same period of accounting as related credit sales. This assists in balancing the debts on the balance sheet. Two bad debt expense formulas are part of the allowance method.
Percentage of Bad Debt:
To calculate your allowance first, you need to determine your bad debt percentage, which is determined by your experience. The percent of bad debt formula:
After you’ve got your results you can calculate it on your current sales on credit. For example, if your bad debt ratio was 2 percent, you could transfer the 2% of your credit sales to your allowance for bad debt. We’ll find out later on how to record this.
The Account Receivable Aging Method:
Another method to determine how much you should budget for your reserve fund for bad debt is to utilize the method of aging.
To accomplish this you must keep the older document in your possession. They tell you where your invoices are across different categories:
- Between 0 and 30 days late,
- 30 to 60 days
- From 61 to 90 days
It’s a fantastic way to see the places where the account receivables are growing. You can then assign the percentage of bad credit to each of the categories.
The rule is that the longer it’s received payment, the lower the chance of it ever being paid. For example, you’d add 1% of bad debt into your 0-30 days category as well as 30% of the past 90 days.
Calculate the amount from your account receivable in each category, and add them together to create all your bad loans. That’s your projected bad credit which you can be able to add to your allowance account.
How to Record Bad Debt Expenses?
If you are now aware of how to calculate the cost of bad debt It is essential to know, when does an account receivable become the category of bad loan? There are several factors to consider:
Bad debt can only occur in the accounting process of accrual.
Based on GAAP (Generally Accepted Accounting Principles) Accrual accounting is a record of transactions once they have been executed.
If your client accepts an invoice, it will be taken into account by your business right immediately as revenue regardless of whether it’s been paid for or not.
If an invoice has to be erased, it must be written out as an expense in your financial statements to be precise.
In the case of cash-based accounting (the reverse of the accrual system) transactions are logged whenever cash moves or is deposited on the company’s accounts. If an invoice doesn’t get paid, there’s no record to make or undo. Technically speaking, there was never any event.
What does the IRS say about bad credit?
According to the IRS, an invoice that is not paid can be considered bad debt when there’s no chance that the due amount will be paid. To be able to claim that, you need to be able to prove that you’ve taken reasonable steps to collect the debt.
So, payment reminders are crucial to your accounts receivables and in particular the recognition of bad debts.
When to write off bad debt for your company
Essentially, you are the person who determines the best time to report bad debts within your company. Depending on your primary method of sales (cash or credit) and your credit policy an alternative timing may be appropriate. Be aware of the matching principle in the case of an allowance technique.
Recording Bad Debt Using the Write-Off Method
In order to record bad debts using the write-off procedure it is easy to keep a note in your account balance.
- The debit will be taken from the account for bad debt expenses.
- Crediting your accounts payable.
- While this method does record the exact amount required to be deleted, it doesn’t respect the matching rules of GAAP.
Recording Bad Debt Using the Allowance Method
If you’re planning to utilize an allowance technique, you’ll have to keep track of your bad debt in a different way. To do this, you’ll need an account called a Contra asset account for an account allowance for questionable accounts.
The account is linked to the accounts receivable account on your balance sheet. it’s a component of your liabilities. There’s also another line, which shows the amount you expect to receive.
How can you improve your accounts Receivables to prevent bad debt?
Once you’ve mastered the concept of the dangers of bad debt and the way to handle it, let’s look at ways to reduce it. The key to success is being active in the management of your accounts receivables.
1. Optimize Your Payment Process
The process of streamlining your payments is about the improvement of your invoicing invoicing, billing, and receivables process. Here are some actions to achieve this:
- Set up clear payment and Credit Policy Set out specific payment terms that apply to different clients, regardless of whether they are small or large-scale accounts. Collaboration with sales personnel to agree on these terms to ensure that everyone is on the same agreement. If needed, establish an approval process in which account managers require validation before accepting non-standard payment terms.
- Make it easier for clients to pay Create it as simple as it is for clients to make payments. This means:
- Invoicing invoices quickly and with all pertinent information including specific payment conditions.
- With multiple payment options including transfer to a bank account and credit card transactions and payment instructions on the web.
2. Be proactive when you receive late Invoices
To prevent bad debt, it is essential to take active control of late invoices. This means taking action before as well as after an invoice is due:
- Set up Receivables Processing Create internal procedures that make managing receivables more efficient and consistent. Consider:
- Set up regular reminders to follow up on outstanding invoices.
- The assignment of specific tasks to team members, ensuring that everyone is aware of their roles.
- Regular check-ins are a good way to monitor the progress made and to address any issues.
- If the entire team is aware of what is required to be accomplished and at the time the process of addressing the overdue invoices is smooth.
3. Leverage Automation to Improve A/R Management
A lot of tasks associated with managing accounts receivable like sending follow-up emails, evaluating the amounts of invoices, and keeping track of KPIs and KPIs, are tedious and lengthy. Utilizing an account receivable CRM Finance CRM assists in streamlining these procedures, allowing you to concentrate on the most important thing to you: stopping bad credit.
- Improve efficiency by automating routine tasks like reminding you to track balances, or making sure that payment terms are adhered to this frees up time to concentrate on the accounts that require the most attention.
- Facilitate Communication between Clients The tools of Upflow allow customers to communicate with us for example, raising issues with invoices directly from their dashboard.
- Enhance Financial Reporting Advanced analytics and tools for automation such as Upflow can help you manage your A/R effectively and make educated choices to guide your business in the proper direction.
Adopting a proactive and systematic strategy for your automated accounts receivable will drastically reduce the risk that bad loans will occur, increase cash flow, and boost the financial health of your business.
Key Takeaways:
- The term “bad debt” refers to an accounting expense that is a write-off of invoicing that is not paid. It’s a premise that invoices are never paid and are part of the operational expenses of managing the business.
- It is crucial to determine your bad debt as it can affect your liquidity. In the end, if a lot of customers fail to pay, it could affect your business.
- How to Calculate Bad Debt Expenses? There are many ways or formulas to calculate bad debt expenses. It is possible, to sum up the manual write-offs you have made in a period of accounting or employ projection models such as the bad debt rate or the aging method.
- In order to comply with GAAP it is necessary to disclose your bad debt through an allowance technique. It’s a forecast of the possible bad debt that is assigned to a particular account. It can help cushion any loss that may occur in the future.
