Bad Debt Expense
A bad debt expense means that a customer can not continue to pay back their loan installments or outstanding debt. That can happen for many reasons. Financial problems like bankruptcy or unpaid debts to other creditors are among the most common issues that can turn a receivable not collectible. However, whenever your company has payments your customers cannot fulfill, it’s vital to record these numbers on the balance sheet. That way, your financial reporting will remain accurate, which demonstrates a good economic condition in your enterprise. Plus, learning to enter the data into your expense journal’s financial documents will help you keep the records current. And this article is here to help you with all that. Here, we’ll take a closer look at the significance of bad debt expenses, cover the reasons why they occur, teach you how to record a journal entry, and more. Sounds good? Let’s dive in!
Significance of Bad Debt Expense
Bad debt expense, by definition, means that there are some bills your business will never receive. So they get documented in financial statements as negative transactions. Here’s why it’s crucial to do that:
- It keeps the books balanced and improves your overview of the cash flow.
- Expensing bad debt shows that you’re in good financial health. It displays accurate income levels and lowers the accounts receivables. As a result, you’ll have better opportunities to collaborate with other businesses and appeal to new clients.
- You’ll also attract investors more likely. They’ll often decide whether or not they want to do business with you by checking your company’s financial documents. Expense journal entries give investors positive and accurate information that can make them decide to go ahead and put their money into your enterprise.
- It helps you pinpoint the defaulted accounts and pick the best strategy to approach them. That can lead to understanding why your clients have failed to make their payments so that you can reduce the impact of unpaid bills on your earnings reports.
- Your financial statements will be more accurate, which is crucial when doing your taxes. The law requires you to report your net income numbers and assets as precisely as possible.
Why Bad Debts Happen
The truth is that all companies that enable credit payments are sooner or later bound to get some clients whose accounts turn uncollectible. If we look at what is a bad debt expense from the customers’ points of view, it’s when they can not cover an outstanding invoice. And that can happen because of numerous reasons, from having financial difficulties because of reduced revenues to filing for bankruptcy. But sometimes, bad debts can also occur because clients refuse to pay after not being happy with your product or service. And when you’re unable to resolve the dispute, the refused payment can become a bad debt.
The Impacts of Bad Debts on Business
Even without doing a bad debt expense calculation, it’s clear that the unpaid invoices hurt any business and its accounting process. The problem is that all sales that didn’t receive money from a client require the accountants to go through numerous reporting and collection procedures to detect when the transaction happened. And if the invoice will not get paid, it will turn into debt. Here are the consequences of that:
- Reduced or even a negative cash flow, which can end in bankruptcy.
- The company’s financial stability gets compromised. The business’s loan payments become the primary factor that affects the organization’s credit policy as its receivables get reduced.
- There will be less profit on the income statement. The bad debt expense gets taken off from the sales revenues.
- If the dunning process should fail to meet its objectives (or there are no clear steps for communicating with non-paying customers), the debts will pile up. That can make it impossible for a company to raise capital and grow its business.
How to Record the Bad Debt Expense Journal Entry
So how to calculate bad debt expense? It all starts with recording them, by making a debit entry. That’s a crucial part of your company’s accounting and enables you to make the best possible financial decisions based on a realistic overview of accounts. Next, you should make a credit entry to the allowance account you’ve set up for customers that can’t pay. On the balance sheet, this so-called contra asset account nets against all the receivables. It gives the accountant an estimation of what’s collectible.
But what happens if you write off a bad debt expense and it gets paid after that? It’s a pretty common situation that usually happens after the receivable gets recovered via legal action. In that case, you should book these payments under bad debt recovery. Plus, keep in mind that you should record this recovery as income and report it to the Internal Revenue Service (IRS).
Bad Debt Allowance Method
The allowance method is when you debit the bad debt expense. You put it down on your balance sheet as a contra asset account. And, at the same time, you credit the allowance you’ve set for bad debts. That enables you to compile more accurate financial statements: you’ll get an overview of the possible losses and avoid overstating the expected income. However, the thing is that a business can not say for sure which accounts will not pay. The sale happened too recently to anticipate a client’s default. So the allowance account gets created based on assumed numbers. It can also grow over multiple periods of accounting, which means there might be a need to adjust the allowance to the account’s balance.
Bad Debt Direct Write-off Method
The direct write-off method of making a journal entry for bad debt expense gets comprised of many steps. First, you need to identify the client accounts that are likely not paying. But how to find bad debt expenses? You can check for your customers’ behavior and habit in paying their invoices. Are there any sudden changes or trends to spot? For example, if someone has paid correctly for a long time but then starts missing the invoice deadlines, it can point to bad debt. Check their account’s receivable, and if it turns out that they’ve failed to make their payments for a long time, write them off.
However, before writing anyone off, give your best to collect the money to keep your financial records clean from the debt issue. Contact your clients to get information on why they can’t pay and devise a realistic payment plan to help them make their payments. And if that won’t help, you can even employ debt collectors. These experienced professionals are skillful in negotiating and getting overdue clients to pay their debts.
But finally, if the debt truly is uncollectible, you can put it down on the balance sheet. You only need to enter the amount lost on payment into two sections: the receivable and allowance for bad debts. And if you need to add its percentage, the bad debt expense formula is pretty simple. First, divide the debt expense by the sum of all income in a set timeframe. Then, multiply that by a hundred. Did you manage to do that? Congratulations! You have written off your bad debt.