Any business that runs accounts receivable will at some point face an uncollectible debt. Eventually, the business will have to face the question: At what point should A/R write-off the bad debt?
It might be surprising to know that there isn’t a simple answer to this question. Businesses vary in their operations and have different criteria for when they should write-off bad debt. Keeping bad debt in A/R will increase A/R and days sales outstanding (DSO).
This increase can skew reports. That isn’t necessarily a bad thing. Knowing the bad debt is there can be motivation to continue trying to collect on it. Always having to look at bad debt can trigger policy changes that improve a company’s credit policy. Another reason to allow bad debts to hang around in A/R is if the client is on a payment plan.
The Accounting Behind Writing Off Bad Debts
There are a number of ways to write-off bad debt. There is also the allowance method, which reinstates the customer’s account back into A/R. Another method is to write-off bad debts as a percentage of sales. Accountants working with a company may have their own way of handling recovered funds from bad debts.
Publicly traded companies that follow the Generally Accepted Accounting Principles (GAAP) and are regulated by the SEC use the direct write-off method. Once the debt has been determined uncollectible, it goes directly from A/R to an expense. There is no intermediate account.
If you don’t want the debt in A/R but still need a way to track, so it isn’t totally written off, an A/R can be created for each collection. This way, the primary A/R can run reports without bad debts affecting it. But each collection will still be trackable in its own A/R account. Basically, these are sub-ledgers.
No matter how bad debt is tracked, there must come a point when it is decided the debt is uncollectible and must be written off.
Once It Goes to Collections
Once a company’s internal collection policy has run its course, the next step is usually hiring a collection agency. The debt is taken out of A/R and written off (i.e., expensed).
After a Certain Number of Days
To keep DSO from being skewed, bad debt might be written off after a certain number of days above the average DSO. For example, if the company’s average DSO is 75 days, it might decide that after an additional 90 or 120 days, the debt should be sent to collections and written off.
DSO is only an example. Some companies pay corporate fees for carrying bad debt. Rather than 165 or 195 days, as in the above example, the company may settle on 150 days in order to limit the carrying expense.
Once a Client Declares Bankruptcy
Once a client declares bankruptcy, there is generally no recovery of anything. This is probably the most straightforward method for determining when to write-off a bad debt. Even a collection agency or judgement won’t do any good in this case.
Cost to Collect Outweighs Debt
If a client has skipped town or become unresponsive, collecting debt just got more time consuming and expensive. The cost, both in money and time, of collecting a debt has to be weighed against the amount of debt being collected.
Judgement Is Unable to Recover Payment
If you win a civil case against a client and are awarded a judgement, you then have to take action to collect payment. This often comes in the form of garnishment.
Even if you have a judgement against a client, it doesn’t mean you’ll be able to collect payment. As previously mentioned, if the client files for bankruptcy, the debt is unrecoverable. If the client has no money, the debt is unrecoverable.
What Happens If the Client Decides to Pay the Bad Debt?
Sometimes you get a gift and, after months, the client pays off the bad debt. You’ve already written the debt off and have even forgotten about it. But the money you just collected is certainly real and must be accounted for. There are a few ways to handle this zombie debt that has suddenly come back to life.
Once a debt is determined uncollectible, it is moved from A/R to a bad debts account. The debt write-off becomes an expense. Should the client decide to pay at some point, the funds can go into a bad debt recovery account. Accounting methods mentioned earlier also have their own way of dealing with recovered funds.
There isn’t any one right reason as to when a bad debt should be written off. It will depend on the specific company. Virtually all companies have one thing in common when it comes to bad debt; it should eventually be written off. Discussing with your team what makes the most sense will help in determining the right time to write off bad debts.