To know more about accounting for bad debts, we must understand how bad debts stack up. This way, you can figure out if you will deal with bad debts with a write-off, provision, or a bad debt collection agency.
What Are Bad Debts?
Bad debt is a receivable that a customer has not or will not pay. The two ways in which a situation of bad debt expense can arise is when the company has extended more credit to the customer than they are capable of paying back, making the payment delayed, missing or reduced. The second instance in which such a case can arise is when the customer misrepresents themselves while obtaining – a sale on credit and does not have any intention of paying the seller.
How Do These Situations Come About?
When you have a customer who cannot pay because they have insufficient funds, then they might have poor internal processes or changes in their ability to pay. If your customer has misrepresented their ability to pay, then they might have intentionally engaged in fraud. Bad debts expense is also related to the company’s existing asset “accounts receivable.”
How to Record a Bad Debt
There are two ways of recording a bad debt, the direct write off method, and the provision or allowance method.
The Direct Write off Method
In this process, the seller can charge the amount not paid from an invoice. The seller charges the amount to the bad debt expense account. This transition can happen when the seller confirms that an invoice is as yet unpaid. The seller considers the journal entry as a debit to the bad debt expense account. But it is also considered a credit to the accounts receivable. It may be necessary to reverse any sales tax that charged on the original invoice, which means a debit goes to the sales taxes payable account.
The Provision Method
The seller can charge the amount that is on the invoice to the allowance for doubtful accounts. The journal entry is debited to the allowance for doubtful accounts and credits the accounts receivable account. Again, it is necessary to debit the sales taxes payable account only if the seller added sales taxes on the invoice.
Why Bad Debts Are Such a Problem
There is no way of knowing how much bad debt you might incur, so you need to make an allowance for potential debts. How you account for these bad debts depends upon whether you used the cash regularly or on an accrual basis of accounting. Using it on a cash basis makes you recognize the income only when a payment materializes. Bad debts are never a problem because you haven’t recorded the profit you were expecting to get.
However, if, like most businesses, you use the accrual method, the process is understandably a little more complicated. This issue is because when you accrue a bad debt only when you sell your goods or services on credit to a customer, who, for whatever reason, does not pay you. It would help if you recognized the income from the sale when it happens. But you may not realize this amount till all of your collection alternatives are exhausted. Such cognizance can take over a year to determine, so you might not even know that a due is a bad debt till a later tax year. Hence, you could end up in a position of recognizing the income that you never received and not realize it until a tax year has passed.
Using a Debt Collector
Using a bad debt collection agency might become a necessity, because if there is a potential of bad debt collecting up, then you would be working at a loss. Instead, if you hire a bad debt collection agency, you can save yourself from having to lose that kind of money and then work out the taxes and the provision for it. Bad debt collection agencies mostly focus on customers who have committed fraud by lying about their financial status or their ability to pay. If it comes to your attention that they never had any intention of funding, the collection agency can do a lot in terms of tracking the customer down and having them pay for the goods or services that you have provided to them.
Why Use a Debt Collector?
If you are a small business, then a lot of times, you cannot afford to accrue bad debt. Instead, you would probably be better off paying a small amount to get your money back with the help of a collection agency and come out of it with more profits. You can put your trust in these companies because they are the best at what they do.