Bad Debt: What is it and how to deal with it?
Bad debt is part and parcel of all businesses that provide their products and services to customers on credit, which has a negative impact on a company's financial health. By provisioning for such outcomes, firms can streamline their operations and prepare better for any significant financial losses.
Bad debt is money that is owed to the company but is unlikely to be paid. It represents the outstanding balances of a company that are believed to be uncollectible. Customers may refuse to pay on time due to negligence, financial crisis, or bankruptcy.
For example, if a company sells its products on credit to a customer who fails to pay according to the terms agreed upon, the sale will be considered a bad debt after all efforts to recover the amount owed have been exhausted.
Let’s illustrate bad debt with an example. Consider a retailer, UK Ltd., that has sold products worth £10,000 to a customer, PZ, on credit. However, PZ files for bankruptcy and is unable to make the payment. In this case, £10,000 becomes a bad debt for UK Ltd.
Bad debt is basically an expense for the company, recorded under the heading of sales and general administrative expenses. But the bad debt provision account is recorded as a contra-asset on the balance sheet.
To record bad debts in the account books, firms must initially estimate their potential losses. Such an estimate is called a bad debt allowance, a bad debt reserve, or a bad debt provision. This provision for doubtful payments is recorded as a contra-asset account on the balance sheet.
Alternatively, many small businesses in the UK that follow IFRS standards may use the bad debt write-off method. In this scenario, bad debt is directly recorded in the books the moment it is clear that the receivable is no longer recoverable. This written-off bad debt is deducted from the accounts receivable balance.
If the actual bad debt amount exceeds its provision, the excess is recorded as an expense in the income statement of the corresponding financial year. This brings down the net profits earned by the firm in that particular accounting year.
Enterprises can also acquire bad debt relief by reclaiming taxes paid on accounts that have gone bad. HMRC offers bad debt relief on VAT paid for invoices older than six months and meeting some of the other conditions listed on the official GOV.UK website.
In order to record the bad debt expense, the firm needs to pass an accounting entry to reflect the loss. The bad debt entry involves a debit to the bad debt expense account and a credit to the contra-asset account called the ‘bad debt provisions account’ or allowance for doubtful accounts’.
When a company believes it will not be able to recover its receivables, it will write off the account as a bad debt. The entry would be a debit to the ‘allowance for doubtful accounts’ and it will be a credit to the ‘accounts receivable account.’
If payments are eventually received for bad debts already written off, they will be recorded in the bad debt recovery account. Alternatively, firms can reverse the previous transaction at the time of writing off the bad debt and record the payment received.
According to the accounting principle of ‘matching’, companies must estimate their bad debt expenses in the year when credit sales were made. Such a bad debt allowance can be estimated via two methods:
Under this method, bad debt is estimated by applying a flat percentage to net sales based on historical experience.
For example, if, based on past trends, 2% of a company’s sales become uncollectible, then, assuming sales of £100,000, £2,000 will be bad debt for that year. Similarly, when the sales rise to £150,000, £3,000 will be the bad debt expense in the next year. The allowance for doubtful accounts will show an aggregated balance of £5,000 for both periods.
In this method, the firm will initially club all outstanding accounts receivable (AR) by age and get an aggregate of the uncollectible amount. It will then proceed to apply specific bad debt percentages based on historical trends and industry data to different age groups.
The rule of thumb is that as the receivables age, the default risk rises in tandem, reducing collections. As per Dun & Bradstreet research, receivables past the age of 90 days only have a 69.6% probability of being collected. This percentage falls to 52.1% in six months, tapering off to 22.8% in a year.
To illustrate, assume a company, TYU Ltd., has accounts receivable of £50,000 and £30,000 outstanding for under 30 days and under 60 days, respectively. As per its historical data, 1% of its 30-day outstanding accounts and 5% of its 60-day accounts will not be collectable. So, the bad debt expense will be estimated as follows:
Bad debt expense = (£50,000 x 1%) + (£30,000 x 5%)
Bad debt expense = £500 + £150 = £650
However, when the bad debts are estimated for the next period, this sum will be reduced. For instance, if the bad debt allowance amounts to £990 in the following period, only £340 (£990- £650) will be recorded as bad debt.
Despite taking preventative steps, conducting extensive credit checks, and establishing credit limits, some invoices may remain unpaid. We highlight main ways to deal with bad debt:
- Prompt follow-up: When a customer fails to make an invoice payment, it is best to immediately follow up by sending them automated periodic reminders in the form of bad debt letters or periodic phone calls to speed up collections.
- Negotiate better terms: You can also offer payment plans to customers facing financial difficulties to hasten your payments.
- Hire debt collection agencies: When reminders fail, debt collection agencies can be an effective way of getting invoices paid. These agencies have the resources and expertise to chase payments from delinquent customers.
Bad debt is the outstanding amount that is owed to the company by its customers but is unlikely to be paid. Firms create bad debt provisions in their accounts to factor in uncollectible payments.