You’ve made a sale, sent the invoice, and are now patiently waiting for the payment to come through. Days pass, maybe weeks or months, and still nothing shows up in your bank account. You send a reminder, maybe make a phone call, and despite your best efforts, you can’t get the money you’re owed.
If you’ve experienced this emotional rollercoaster, you’re not alone. It’s not uncommon for businesses to have invoices go unpaid to the point that they’re deemed uncollectible.
But all is not lost when this happens. Despite the sting of never receiving payment, there’s still a way to get some value from unpaid invoices, and it’s done with bad debt expense.
What is bad debt expense?
Bad debt expenses occur when a customer defaults on their bills or outstanding payments. It reflects the value of credit provided that will ultimately not be paid.
Typically, bad debt expense refers to credit sales to customers (also called uncollectible accounts). But it also includes loans to clients, suppliers, distributors, or employees.
The amount that a business can’t collect is reported as a tax deductible operating expense (if meeting certain criteria) and reduces the net income reported.
By reducing net income, businesses get a clearer picture of their overall financial health. And by reporting bad debt expense as a tax deduction, the business reduces its taxable income and saves money on its tax bill.
Bad debt expense vs accounts receivable
The most common form of bad debt expense refers to uncollectible accounts receivable.
Accounts receivable covers any sales that are made on credit, typically done through invoices. The owed amounts are reported on the business’s balance sheet as an asset.
Once an amount of accounts receivable is decided to be uncollectible, it is reported as bad debt expense.
Accounts receivable are only used by businesses using the accrual accounting method. If you’re using the cash basis of accounting, you only record a sale when payment is received. This means you wouldn’t record bad debt expense on your books because that sale would never have been recorded in the first place.
Why do businesses calculate bad debt expenses?
There are two main reasons businesses calculate bad debt expenses.
Under the accrual method of accounting, sales are recorded when a customer is billed. If those payments aren’t collected, the income statement will show a high net income that doesn’t reflect the cash activity of the business. Calculating bad debt expenses adjusts net income such that it’s closer to the cash reality.
Additionally, bad debt expenses are tax deductible. While you may not collect the payment, you’ll at least save money on your taxes, making up for some of the value lost.
What causes bad debt?
At the core of bad debt is customers unable or unwilling to pay their outstanding invoices. Some common causes of bad debt include:
- Financial hardships, including filing for bankruptcy
- Economic factors are putting a strain on their cash flow
- Disputed invoices
- Issues with the delivery of the product or service
- Fraudulent customers placing orders without intent to pay
Bad debt may come from innocent reasons, deliberate intent to deceive, or disputes over the goods or services provided. Regardless of the cause, it’s important to know when to cut ties and report the loss.
How to calculate bad debt expense
There are two methods businesses use to calculate bad debt expense.
Direct write-off method
The direct write-off method involves writing off outstanding invoices on a case-by-case basis.
The process is straightforward: you identify an outstanding invoice that won’t be paid and record it as a bad debt expense.
This method is favored by businesses that either have a small volume of invoices or are reliably paid by their customers. If unpaid invoices are a rare occurrence, you can use the direct write-off method to account for any that arise.
Allowance method
The allowance method assumes that a certain portion of credit sales will go unpaid.
Instead of accounting for an unpaid invoice when it happens, the business proactively sets aside a portion of sales as “doubtful debts.” For example, if historically 5% of all accounts receivable become bad debt, 5% of future sales would be proactively categorized as doubtful debt.
Think of it as setting aside money to cover the cost of unpaid invoices. If customers don’t pay, the books have already accounted for it.
This allowance is held in a contra-asset account called allowance for bad debt. Contra-asset accounts are found in the asset section of the balance sheet, but hold a zero or negative balance.
The allowance method is used by businesses that do a large volume of sales on credit and have a proven history of bad debt. Rather than record bad debt on a case-by-case basis, they do it in a single adjustment.
Recording bad debt expense as journal entries
You have an unpaid invoice that has now become bad debt, and you’re ready to report it on your books. Now what?
Bad debt expense involves making a double-entry accounting journal entry, and here’s how.
Direct write-off method journal entry example
The direct write-off method is the easiest bad debt expense method to make a journal entry for. All that you need to know is the amount of the invoice that you are writing off.
Once you have that amount, you will create a journal entry with two parts:
- A credit of accounts receivable, which reduces the balance and amount outstanding
- A debit of bad debt expense, which increases the amount of the expense reported on the income statement
Let’s say a business has an invoice of $1,000 that is deemed uncollectible. In action, the journal entry looks like this:
Bad debt expense journal entry
Allowance method journal entry example
The allowance method journal entry is a two-step process and involves an additional account: allowance for doubtful debts.
To use the allowance method, the business must assume a certain percentage of sales to become bad debt. This percentage is often based on a bad debt percentage from a previous period. To calculate the percentage of bad debt, use the formula below.
The two steps of the allowance method are the initial bad debt expense calculation, followed by adjusting for any uncollectible invoices.
To illustrate this, let’s say a business has recorded $100,000 in sales and has a 5% percentage of bad debt. The initial recording of bad debt expense looks like this.
Bad debt expense journal entry
In the same accounting period, an invoice for $1,000 is being written off as the customer defaulted on the amount. They make another adjusting journal entry for this amount.
Bad debt adjustment journal entry
In other words, the two steps in the allowance method is adding to the allowance for doubtful debts balance, then decreasing the balance based on any invoices that are written off.
The impacts of bad debts on financial statements
Bad debts affect two financial statements: the income statement and the balance sheet.
On the income statement, bad debt expense is recorded as an operating expense (specifically, an administrative expense). Any bad debt expense that is calculated and recorded will reduce the net income reported at the bottom of an income statement.
On the balance sheet, the impact of bad debts depends on the method of calculation.
For businesses using the direct write-off method, the accounts receivable ledger is reduced for every invoice that’s been written off. Writing off an invoice will create a bad debt expense and reduce the accounts receivable ledger for the same amount.
With the allowance method, a new account is added to the balance sheet: allowance for bad debts. More specifically, allowance for bad debts is a contra-asset amount, meaning it holds either a negative or zero balance.
In both cases, a business’s assets are reduced by the inclusion of bad debt. While this may not seem like a positive thing, it does give the business the most accurate view of its financial health.
Strategies for Minimizing Bad Debt Expense
When you make sales on credit, bad debt is likely to arise at some point. However, savvy businesses minimize the impact of bad debt by taking a proactive approach to their billing and communication.
The best tactics for minimizing bad debt are:
- Incentivize early payments: Offer early payment discounts to get customers to pay as fast as possible. And use late fees or interest on late payments to discourage letting debts slide.
- Follow up on unpaid invoices regularly: Send payment reminders to notify customers of their unpaid debts and remind them of any consequences of late payments.
- Freeze unreliable customers: If a customer has unpaid debts, simply stop working with them until they’ve paid.
- Adjust your payment terms: Consider shortening your payment terms to create a greater sense of urgency around invoice payments.
- Run credit or reference checks: For large-scale customers with high sales amounts, a credit check or contacting other suppliers they work with can give you the peace of mind that they’re reliable and willing to pay.
- Regularly review your customer base: Review the average time to pay across your customer portfolio. If someone is typically late, you can renegotiate your agreement with them or cut them from your customer portfolio.
- Offer installment payments: For customers who are late on payments because they’re cash strapped, installment payments give them the opportunity to pay in approachable amounts rather than waiting til they have the full amount.
Protecting your business against bad debt
Recording bad debt expense on the books provides benefits in the form of tax deductions, but the best-case scenario is no bad debt at all.
To protect your business against bad debt, you could consider Trade Credit Insurance (TCI). Trade Credit Insurance is designed to protect businesses against the impact of unpaid invoices by offering compensation on payment defaults and, if needed, debt collection services.
You could also consider using a collections service or invoice factoring. However, these services can negatively impact your relationships with customers and are best used as a last chance effort.
Ultimately, the best protection is to be proactive and recognize the signs of bad debt before it happens. Keep track of your customers' time-to-payment and see if they’re trending in the wrong direction.
If the customer is worth keeping, reach out to assess the situation and determine if a mutually beneficial solution is available. However, if the customer is problematic, you may want to consider discontinuing your work with them.
Minimizing bad debt with accounts receivable automation
For small and medium-sized businesses, creating and sending invoices is already a time sink. Dedicating time to generate reports, track customer payments, and send reminders could save the business from bad debt, but where the time comes from is a whole other consideration.
None of this is a problem when you use an automated accounts receivable platform, like BILL. We streamline the accounts receivable process with easy-to-use templates, automated recurring invoices, simplified follow-up, and auto-pay methods.
Plus, our integrations with top accounting platforms ensure your accounting stays in sync with invoices and payments being recorded without lifting a finger.
You can see for yourself how a simple switch will save you time and bad debt by scheduling a demo.
