What is Bad Debt and What Can Your Business Do About It?
The term "bad debt" might be misunderstood as referring to all debts incurred by a business, but that's not accurate. In the context of running a business, accumulating some form of debt is common. However, bad debt is an accounting term that describes situations where issued invoices for goods and services remain unpaid. Timely payment from customers and partners is crucial for a business's profitability and competitiveness. Delays in receivables can lead to cash flow problems, impact the break-even point, and affect the overall Return on Investment (ROI). To manage bad debt effectively, business owners need to understand its definition, causes, proper recording for tax purposes, and its potential impact on their businesses. This article offers clarity on bad debt and its management.
What it means to have bad debt
As defined in accounting terms, bad debt is a receivable that cannot be recovered. This is known as a bad debt expense. Bad debt is an expense that happens when a business extends credit to a customer and the customer refuses to pay an invoice or is not in a position to pay the invoice. Any business that allows its customers to purchase goods or services using credit has an increased risk of bad debt.
Why does a business end up with bad debts?
Often, credit is given to other businesses rather than private individuals. A bad debt can occur when a company goes into insolvency or bankruptcy and is then unable to make payments on its existing credit purchases.
A bad debt can also be the result of a customer experiencing supply issues. If a business cannot produce goods or offer services, it cannot generate enough revenue to pay its accounts received.
Being turned down for a loan or having a line of credit closed by a financial institution can also leave a business in no position to make good on its debts.
In terms of private customers, it may be that the business has simply made a bad decision and extended credit to a customer that has turned out to be a risk. Many businesses do not perform vigorous credit checks on their customers. Bad debt may also happen due to fraud. A common occurrence is for purchases to be made by criminals using stolen credit cards.
If your bookkeeper or accountant is noticing that a high number of invoices are being paid late by a particular customer, this can be indicative of a potential bad debt.
How to record bad debts for your business
The way that the bad debt is recorded will depend on what country your business operates in. Businesses that are based in the United Kingdom use the international financial reporting standards (IFRS). Businesses in many other parts of the world, such as the United States, use methods laid out by the generally accepted accounting practices (GAAP).
Whichever accounting method you are using, there are two accepted methods of classifying and recording bad debts. A bad debt can be reported as a bad debt provision or as a bad debt write-off.
The bad debt write-off method
The bad debt write-off method is used whenever a business has a specific and recognisable bad debt on its accounts. This means that the business owner and the accountant recognise that the debt is never going to be paid - that it is irrecoverable.
To record a bad debt write-off, the bookkeeper debits the bad debt expense for the amount of the write-off and credits the accounts receivable account for the same amount. It must be noted that this method is usually used by UK-based businesses since bad debt write-offs do not comply with accounting requirements as laid out by GAAP.
The bad debt provision method
The bad debt provision allowance method is also known as a provision for doubtful debts. Using this method, a business accountant will estimate the amount of bad debt that may be needed to be written off within a certain period, be it a financial year or an accounting cycle.
The estimated amount is charged to the accounts receivable and then debited from the bad debt expense account. The bad debt provision contra account is then credited for the same amount.
Claiming relief from VAT on bad debts
If a UK-based business has provided goods or services to a customer and has not been paid, they may be able to claim relief from the Value Added Tax (VAT) owed on the invoice. If your business is registered for VAT and has not been paid for goods or services, then you can claim VAT relief if you meet the below conditions:
- The VAT must have already been accounted for and paid to His Majesty’s Revenue and Customs (HMRC)
- The debt must have been written off in your daily VAT accounts and transferred to a bad debt account
- The value of the goods or services must not exceed the usual selling price
- The debt must have been incurred under a valid legal assignment
- The debt must have remained unpaid for at least six months after it was due
- Goods supplied before 19 March 1997 must have been passed to the customer or to a third party by your customer
- VAT-registered customers must have been sent a notice for supplies made between 26 November 1996 and 30 April 1997. A copy must be kept
To make a claim, fill out the details in box four of the VAT Return for your business.
Why it is crucial for business owners to understand bad debt
Even a profitable, highly successful business can develop severe financial difficulties if it incurs too many bad debt expenses. A bad debt can impact the cash flow of your business and reduce its working capital. A large amount of bad debt will negatively impact your financial statements. When these statements are analysed or audited, your business may show a high break-even point or a low ROI percentage, making it an unattractive risk to potential lenders or investors.
This is why it is important for business owners to try and control the amount of bad debt that they have on their books. If a customer is late in making payments, reminder notices should be sent out and followed up on. If necessary, legal advice should be sought and representation engaged.
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