If you do business on creditâi. e. Give your clients terms for payment such as Net 30 and Net 15; eventually, you’ll come across a client who is unable or unwilling to pay you. This type of uncollectible debt is referred to as bad debt (or a doubtful debt) from your customers. Whats Bench?Online bookkeeping and tax filing powered by real humans.
Upon ultimately giving up on a debt (which is typically represented by a receivable account) and choosing to delete it from your business’s records, you must do so by documenting an expense. We call this a bad debts expense.
Here, we’ll explain exactly what bad debt expenses are, how to calculate your bad debts, where to find them on your financial statements, and how to accurately record bad debt expenses in your bookkeeping.
Navigating the intricacies of bad debt can be a daunting task for businesses of all sizes. This detailed guide will delve into the two primary methods used to determine bad debts written off, empowering you to make informed decisions and maintain accurate financial records.
Understanding Bad Debt
Bad debt refers to the portion of accounts receivable that a company deems uncollectible These debts arise when customers fail to fulfill their payment obligations, resulting in a financial loss for the business Identifying and writing off bad debts is crucial for maintaining accurate financial statements and ensuring a clear picture of the company’s financial health.
Methods for Determining Bad Debts Written Off
Two primary methods are employed to determine bad debts written off:
1. Direct Write-Off Method
Using this simple technique, individual accounts receivable are written off as uncollectible when it becomes unlikely that they will be collected. This method is often used by smaller businesses due to its simplicity. But it doesn’t follow the accrual accounting principle, which says that costs should be allocated to the period in which they are incurred.
2. Allowance Method
The allowance method, also known as the percentage of sales method, estimates the amount of bad debt expense based on historical data and industry trends. This method aligns with the accrual accounting principle, providing a more accurate representation of the company’s financial performance.
Steps for Implementing the Allowance Method:
- Calculate the percentage of bad debt: Divide the total amount of bad debts written off in the past by the total credit sales during the same period.
- Estimate the allowance for doubtful accounts: Multiply the percentage of bad debt by the current period’s credit sales.
- Record the bad debt expense: Debit the bad debt expense account and credit the allowance for doubtful accounts.
- Write off individual accounts: When an account is deemed uncollectible, debit the allowance for doubtful accounts and credit the accounts receivable.
Additional Considerations:
- Regularly review and adjust the percentage of bad debt based on current economic conditions and industry trends.
- Document the reasons for writing off individual accounts to support the decision-making process.
- Consult with a qualified accountant or financial advisor for guidance on implementing the most appropriate method for your business.
Determining bad debts written off is a crucial aspect of financial management. By understanding the different methods and implementing the appropriate one, businesses can ensure accurate financial reporting, maintain a clear picture of their financial health, and make informed decisions regarding credit extension and collection efforts.
Remember, this guide provides a general overview of the topic. For customized advice for your company, speak with a licensed accountant or financial advisor.
How to directly write off your accounts receivable
If you don’t have many bad debts, you’ll likely write them off one by one as soon as it’s evident that a client is unable or unwilling to make payments.
If so, all you have to do is enter a bad debt expense transaction in your general ledger for the amount of the account receivable (you can make a bad debt expense journal entry by following the instructions below).
How do you know whether itâs time to write a bad debt off as uncollectible?
According to the IRS, you should only write off a debt once there is âno longer any chance the amount owed will be paid.â You must be able to demonstrate that youâve âtaken reasonable steps to collect the debt.â If youâve tried (and failed) to contact the customer by phone or set up a repayment plan, it might be time to write off the debt.
What is the percentage of bad debt formula?
Because you set it up ahead of time, your allowance for bad debts will always be an estimate. The percentage of bad debt formula, which is simply your past bad debts divided by your past credit sales, is typically used to estimate your bad debts.
The formula is:
Percentage of bad debt = Total bad debts / Total credit sales
Let’s say that after a year of operation, $20,000 of the $300,000 in credit sales you made in your first year became uncollectible. To account for these bad debts in advance, you should set up an allowance for them. How big should the allowance be?.
First, youâd figure out your percentage of bad debts:
Percentage of bad debt = $20,000 / $300,000
Percentage of bad debt = 6.67%
If 6. 67 percent seems like a fair estimate for future accounts that are uncollectible, so you would then make an allowance for bad debts equal to 67% of this yearâs projected credit sales.
If your credit sales for January total $50,000, you may record an adjusting entry for $3,335 to your Allowance for Bad Debts account on January 30.
However, this isn’t always a good way to forecast future bad debts, particularly if you haven’t been in business for very long or if your percentage of bad debt is distorted by one large bad debt.
Writing Off Bad Debts – Accounts Receivable
FAQ
How do you calculate bad debt written off?
What are the rules for writing off bad debt?
How are bad debts determined?
How long before a bad debt is written off?
|
Type of derogatory mark
|
Length of time
|
|
Money owed to or guaranteed by the government
|
7 years
|
|
Late payments
|
7 years
|
|
Foreclosures
|
7 years
|
|
Short sales
|
7 years
|
How to calculate bad debt expense?
Likewise, the calculation of bad debt expense this way gives a better result of matching expenses with sales revenue. Under the percentage of sales basis, the company calculates bad debt expense by estimating how much sales revenue during the year will be uncollectible. For example, the company ABC Ltd. had $95,000 credit sales during the year.
How to write off a bad debt?
A bad debt can be written off using either the direct write off method or the provision method. The first approach tends to delay recognition of the bad debt expense . It is necessary to write off a bad debt when the related customer invoice is considered to be uncollectible.
How do you estimate bad debts?
Businesses also prepare an aging schedule to estimate the bad debts. You need to set aside an allowance for bad debts account to have a credit balance of $2500 (5% of $50,000). The percentage of sales of estimating bad debts involves determining the percentage of total credit sales that is uncollectible.
How do I report bad debts?
If you’re using the write-off method to report bad debts, you can simply debit the bad debt expense account and credit your accounts receivable. To use the allowance method, record bad debts as a contra asset account (an account that has a zero or negative balance) on your balance sheet.