Any business that runs accounts receivable will, at some point, face an uncollectible debt (also known as a bad debt or a doubtful debt). It's the same for businesses that offer net terms. They'll have to face the question: At what point should A/R write off the bad debt?
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, but it isn’t necessarily a bad thing. Knowing the bad debt is there can be motivation to continue trying to collect on it. And, that bad debt can trigger policy changes that improve a company’s credit policy. If you're able to transfer the customer to a payment plan, it makes sense to keep the debt on the books until it's paid in full.
The general rule is to write off a bad debt when you're unable to contact the client, they haven't shown any willingness to set up a payment plan, and the debt has been unpaid for more than 90 days.
There are a number of ways to write off bad debt. Regardless of the method chosen, you'll need a journal entry that balances a bad debt entry. One method is the allowance method, which takes the bad debt amount into a specific allowance for bad debts account (see below for more about this account). This allowance will be a contra-asset account.
Another is the direct write-off method where you make a debit journal entry under bad debt expense and a corresponding credit entry under accounts receivable. (If your company has a full-time accountant, they'll likely already have their own way of highlighting doubtful accounts and handling 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 reflected in the financial statements.
If you don’t want the debt in A/R but still need a way to track it, so it isn’t totally written off, you may want to create a separate A/R account for each collection. This way, the primary A/R can run reports without bad debts affecting it, but you can still track each collection 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—no matter the amount of bad debt. We'll look at a specific solution to avoid this problem further down. Before you write off the debt, you'll need to be able to prove to the IRS that you've taken sufficient steps to collect the debt, because bad debts lower your business' taxable income.
Note: Recording a bad debt expense is only needed if you work with accrual accounting. If you use cash accounting, you won't have an entry for the collectible amount because you never received payment. Unfortunately, it still creates a problem for cash flow.
Once a company’s internal collection policy has run its course, the next step is usually hiring a collection agency.
To keep DSO (daily sales outstanding) from being skewed, bad debt might be written off after a certain number of days. For example, if your company’s average DSO is 75 days, you 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.
You should always be able to see your bad debts on your general ledger. They get listed on your income statement under 'selling, general, and administrative costs' (SG&A). Remember that your bad debts will influence your net income and you may need to look at how you handle your financial obligations if you have too many outstanding accounts in your books.
The formula is pretty simple:
Percentage of bad debt = Total bad debts/Total credit sales
Startups and small businesses are advised to set up a bad debt allowance account (also known as a bad debt expense account or bad debt reserve) in advance of issuing credit. If you're reading this, you may already have bad debts. The 'good news' is that you can calculate your current percentage of bad debt, and set up an allowance for bad debts that you can draw from to cover the amount of your bad debts.
According to GAAP principles, you can either estimate the amount of bad debt based on the percentage of sales method (shown above), or the percentage of accounts receivable method. In the second method, you'll calculate:
Total bad debts/Total accounts receivable
You'll also set up a receivable aging schedule to estimate the bad debts.
In a perfect world, you'd never do business with a client who couldn't pay their invoices in a timely manner—you'd never have to record bad debt! We can't offer that (yet), but with digital net terms, we're getting much closer.
Resolve Pay is a digital net terms partner. Resolve’s credit assessment uses proprietary financial databases and algorithms to assess your customers without needing a single thing from them. When a customer is approved, Resolve provides an advance of up to 90% of each invoice, paid into your account within 1 day.
This means you can check the creditworthiness of any potential client before extending net terms, and you'll be confident that the net terms and credit limit you're offering them are appropriate for their payment abilities. Your receivable balances will always be manageable and healthy.
Too often, sales professionals rely on intuition and past experience to recommend net terms. Now, you can use Resolve and virtually eliminate uncollectible accounts.
If a client has closed down their physical premises or becomes unresponsive, collecting debt becomes more time-consuming and expensive. When this is the case, the cost—both in money and time—of collecting a debt has to be weighed against the amount of debt being collected.
If you win a civil case against a client and are awarded a judgment, you then have to take action to collect payment. This often comes in the form of garnishment.
Even if you have a judgment against a client, it doesn’t mean you’ll be able to collect payment. If the client files for bankruptcy, the full amount of the debt may be unrecoverable. If the client has no money, the debt is unrecoverable.
Sometimes you get a surprise payment of a bad debt that you've already written off. The money you just collected is certainly real and must be accounted for.
As we've mentioned, once a debt is determined uncollectible, it's moved from A/R to a bad debts account and it becomes an expense. You may create an adjusting entry so the funds can go into a bad debt recovery account. Accounting methods mentioned earlier have different ways of dealing with recovered funds.
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.