In a perfect world, all customers would repay their debts. Unfortunately, this doesn’t always happen: The reality is that there will always be some uncollectible accounts, leaving creditors to deal with bad debt.
If your business is hit with more bad debt than anticipated, you could run into cash flow problems and even risk bankruptcy. Underestimating non-payment risk is common because it’s so difficult to collect enough customer data to understand behavior and determine the risk of non-payment.
This is a widespread problem in the U.S. Provisions and write-offs for bad debt went up by over 25% from 2019 to 2020, and experts suggest that organizations will have to work harder to gauge customer behavior and predict non-payment risk.
Fortunately, if you know how to track your business’s bad debts and calculate the bad debt expense, you can stay one step ahead.
What is Bad Debt?
Bad debt is the dollar amount of receivables your company doesn’t expect to receive. Basically, for one reason or another, the customer isn’t going to fulfill their obligation to pay.
Usually, a business won’t call an outstanding invoice or loan a bad debt until it meets a certain threshold. For example, if you’ve tried to recover the debt and the client doesn’t respond to your communication or refuses to pay, you know you have a bad debt expense on your hands.
According to the IRS, a bad debt is a loss from the worthlessness of a debt, such as the following:
- Loans to clients, suppliers, distributors, and employees
- Credit sales to customers
- Business loan guarantees
Bad debt can also complicate tax season. But if you listed the amount as income, you can deduct your bad debts when determining your taxable income as long as you have evidence a client won’t pay and you’ve taken reasonable steps to recover the amount.
Why Does Bad Debt Occur?
Bad debt occurs for several reasons, such as financial distress, poor communication, and disagreements.
For example, if a client goes bankrupt, they might not be able to pay their invoice, so the unpaid amount becomes bad debt. If you loan money but aren’t clear on the terms, you might lose all or part of the debt simply because of miscommunication.
There are also times when a client can pay an invoice but decides not to. Say you have a flower business and a client orders bouquets for a conference, but the flowers are wilted upon arrival. In response, your client refuses to pay the invoice. That unpaid receivable is a bad debt expense.
What Happens When Bad Debt Occurs?
Lenders end up with bad debt when a borrower stops paying a loan. This can happen in all types of lending, from business-to-business (B2B) lending to consumer auto loans.
For instance, when a factoring company lends a client money, but the outstanding receivables become uncollectable, it goes into the unpaid folder and can be listed as a bad debt.
The fact is that bad debt is a part of doing business. As such, it’s an expense you should track and record to ensure you’re maintaining an accurate picture of your business’s financial health and not overestimating your revenue.
Recording Bad Debt Expenses
Your business should record bad debt expenses if you use accrual-based accounting, which is recommended by Generally Accepted Accounting Principles (GAAP) standards.
Accrual-based accounting is all about recognizing revenue before it arrives in your bank account, and most businesses tend to opt for this method. However, some smaller companies might use cash-based accounting because bookkeeping is less complex.
With cash-based accounting, you record a payment when you receive it. That means you wouldn’t record an unpaid debt as income on financial statements, so you wouldn’t need to cancel out unpaid receivables by listing bad debt expenses.
As a lender or B2B company, you probably use accrual-based accounting and list uncollectable receivables as bad debt expenses. In that case, you can use two recording methods: The direct write-off method and the allowance method.
Direct Write-Off Method
This method can work if you have a small number of bad debts. If you have several, you run the risk of misstating your net income every time the bad debt entry happens in a different period than the sales entry.
To create a journal entry, debit the bad debt expense and credit the accounts receivable balance for the same amount. You would record bad debt expenses in a bad debt expense account as soon as you realize a debt is uncollectible.
Here’s what your journal entry should look like:
Lenders and businesses that expect a portion of their receivables to go unpaid are better off using the allowance method.
To record bad debt expenses using this method, you’ll use a contra-asset account on your balance sheet (a contra-asset account has a zero or negative balance) and an allowance for doubtful accounts (AFDA), which is an estimate of bad debt expenses based on your historical averages.
Here’s what your journal entry should look like:
The idea of using the allowance method is to understand how much bad debt your business is likely to incur so you can plan ahead. Then, instead of running into surprise cash flow issues, you can factor an allowance account into your budget.
This allowance is your bad debt reserve, also known as the ‘allowance for doubtful accounts.’ It offsets the amount in your accounts receivable in your books. But you need to know how to calculate the bad debt expense percentage to estimate what your allowance should be.
How to Calculate Bad Debt Expense Using the Bad Debt Expense Formula
To calculate bad debt expenses, divide your historical average for total bad credit by your historical average for total credit sales. This formula gives you the percentage of bad debt, which you can also think of as the percentage of sales estimated to be uncollectable.
Here’s the bad debt formula:
Percentage of Bad Debt = Total Bad Debt / Total Credit Sales
Let’s look at an example:
Your lending business, on average, has $500,000 in sales each year. Your average bad debt expenses total $10,000. So your percentage of bad debt would be 2%.
$10,000/$500,000 = .02 x 100 = 2%
Now, you can use this percentage to estimate bad debt for your current period and determine your bad debt reserve.
Here’s the formula for calculating the bad debt expense. It’s almost the same formula as above, but the unknown variable has changed, and you’re calculating for the current period instead of looking at your historical averages.
Percentage of Bad Debt x Total Credit Sales = Bad Debt Allowance
Let’s say your business has $450,000 in sales for the current year, and you want to know what your bad debt allowance should be. Since your bad debt is 2%, you’ll multiply that by your total sales.
.02 x $450,000 = $9,000
The final number, $9,000, shows us that your company should decide to set aside $9,000 to allow for bad debt. Calculating your bad debt is essential to understanding your business’ liquidity because now you know that you have to account for $9,000 in lost income.
Mitigating Bad Debt Risks
LoanPro is the answer to mitigating bad debt risks in the business world. While bad debts might be a fact of life, it doesn’t mean you can’t take steps to prevent them. Here’s what you can do with LoanPro:
- Communicate clearly about your repayment terms. You can do this by sending out due dates on invoices and sending automatic payment reminders to borrowers.
- Set late fees. If you build late fees into your payments, you motivate customers to pay on time.
- Remind customers about late payments. If your client or a borrower is overdue, send them an automatic email reminder.
- Automate the tracking of bad debts. LoanPro’s automation enables you to catch bad debts instantly so you can try and resolve them quickly. With manual tracking, on the other hand, it’s easy to overlook signs that an account will become uncollectable until it’s reached a point of no return.
The more equipped you are to prevent bad debt, the easier it is to mitigate the non-payment risk and stay in control of your cash flow so your business consistently receives on-time payments and has a smaller chance of running into financial distress.
Understanding your bad debt expenses allows your business to plan ahead, determine lost income, and help prevent cash flow issues.
What’s even better is that you can take things one step further and try and prevent bad debts if you have the right software. With loan servicing software like LoanPro, you can mitigate risks and improve relationships with your customers at the same time.
LoanPro is a feature-rich loan management system that lets you automate payment reminders, communicate with customers, and gather customer data, so you know which customers are likely to pay on time. Contact LoanPro to schedule a live product demo with one of our knowledgeable lending experts