Accounting for Bad Debt: How to prepare for and improve your bad debt
It sounds bad, but is it really that bad?
Yes. Yes, it is.
“But hang on, isn’t all debt bad?” I hear you ask.
Not necessarily, having debts themselves isn’t terrible, as it means you’ve received something in return, but when you are owed a debt that you’ll never receive, it’s not good, it’s er, bad…
So what is it about bad debt that makes it so, well, bad?
Well in this article we’re going to find out exactly that, and what implications it has for the business owners, lenders and investors.
What is bad debt? And how does it happen?
If you are “in debt”, then debt is a type of liability, that is monies owed to a person or business.
However, on the other side, debt that is owed to your business is an asset, and if that asset isn’t paid for it becomes an expense, until that asset is written off.
Bad debt is credit that has been lent to a business or person that cannot be paid back – the debt will never be recovered.
This is ultimately what makes bad debt so bad, it’s bad news for the business or person who has been lent the money and it’s bad news for the lender – as they will not be paid back in full.
But how does this happen?
Bad debt can occur in a number of ways. But some of the most common catalysts are:
- When a lender provides credit to an unsuitable candidate
- Selling goods or services on credit (customer receives the goods but pays later)
It can also occur when the customer goes bankrupt or even result from criminal activity, i.e fraud – but this is more rare.
The financial crisis in 2008 actually stemmed from bad debt! But let’s not delve into that here…
But, more importantly, can you stop bad debt from occurring?
The answer is, disappointingly, no, unless you are prepared to change your business model and not offer goods or services on credit.
But, you can mitigate it and prepare for it.
As a provider of goods and/or services on credit, a business must be prepared and expect that some of their customers will not pay.
It’s, unfortunately, all part and parcel of being a business that provides goods and services on credit.
This is an assumed risk of being a business of this type and if you have been trading long enough, you’re going to encounter some bad debt.
But that doesn’t mean you should never offer your products or services on credit.
Credit gives customers more ways to pay and spreads out payments over time.
By doing this you open up your product/service to more people than if you required the immediate receipt of cash on sale.
But! What do you do when the inevitable happens?
How to calculate bad debt
There are two ways to estimate and calculate your bad debt, you should use them both in conjunction to help you remain on top of your bad debt throughout the year.
The allowance method offers a proactive approach
A smart business will prepare and calculate a percentage of their sales that they predict will default and become bad debts.
This proactive forecast ensures that your balance sheet is as accurate as possible throughout the year.
The goal here is not to create a perfectly accurate forecast (which is impossible) but to get as close to reality as possible.
This ensures that you can have an educated picture of where your business is heading.
Refining this over time will help you predict how well your business will handle different possible future events – both good and bad.
If you can simulate the future of your business you can prepare for it – making better decisions in the short term.’
So, how is this done?
It’s actually pretty simple.
But there are some prerequisites.
Ideally, you should know how many of your sales in the previous trading year became bad debt.
And you should know your average order value. Your average order value is the average amount a customer spends with you.
You can then use this to create a percentage.
- You made 1000 sales last year
- Your average order value was £30
- 50 of those 1000 sales became bad debt.
- This means 5% of your sales became bad debt.
- Totaling losses of £1500.
- You’ll then charge this to the income/profit and loss statement in the bad debt account.
You can carry this knowledge forward to next year, including an estimate for scaling.
Perhaps next year you’ll make 2000 sales, so you should estimate that the number of bad debt sales will increase in line with your overall sales. Meaning that next year you’d have 100 sales that result in bad debt and losses of £3000.
Just because you assume this will become bad debt, it doesn’t mean it will. At the end of the financial period you should look at your actual vs your forecasted estimate for bad debt and make the necessary adjustments for your end of year balance sheet. This will inform the next year’s forecast of bad debt.
Being reactive using the direct write-off method
With this method, you charge bad debt directly to the profit and loss statement as soon as it’s recognised.
The direct write-off method requires you to be more on top of recognising your bad debt, and is ultimately more work.
Instead of estimating it once per year as you’d do with the allowance method, you need to charge your balance sheet every time bad debt occurs.
Now if you’re a small business, this might not be such an issue, you might not even get any bad debt!
But if you’re a large business taking thousands of orders a day, then this will quickly become a problem, bad debt can get forgotten and not accounted for.
How to improve your bad debt situation
Bad debt can be managed if you are prepared for it.
Preparation through effective and well-estimated forecasts can help you do this.
By using the allowance method above, you can estimate your bad debt. But you shouldn’t stop there.
The best practice for forecasting and scenario testing is to create multiple scenarios, by doing this you can prepare for most eventualities.
After all, if you’re prepared for the worst, it won’t be a surprise!
Forecasting is only part of the solution though, you need to accurately track your actual bad debt as it comes through. This will allow you to ensure that your bad debt is not significantly higher than expected.
But, what if the worst happens and your bad debt is much higher than expected?
Well ideally, you will have planned for this when creating your bad debt scenarios, but here are some steps you can take:
- Stop offering your goods and services on credit (temporarily). This will ensure that any sales are immediately coming through to your cash flow
- Offer a discount to customers paying cash, or upfront payments – an incentive to customers to make cash payments up front could help cash flow.
- Take a look at your policies for credit payments, perhaps your credit length is too long? Or too short? Looking at your data for when debt becomes bad will give you an indication of where things are going wrong.
- Perhaps look into a debt collection agency for following up on doubtful debt, that may become bad.
Ultimately, you might find that if things get really bad you need to use a combination of these steps to curb your bad debt and get things back on track.
So we’ve established bad debt is, well, bad, but…
It’s not all bad news…
Bad debt can, in theory at least, be written off on both business’ and individual’s tax returns.
This bad debt has to be recorded prior to being written off, establishing the importance of recording your bad debt.
Be warned though, claims for large amounts of bad debt are likely to be investigated by HMRC (in the UK), so only record what actually happens. This is why, if you use the allowance method you still need to accurately keep a record of bad debt.
It’s always a good idea to check with the relevant tax authorities for how you can write off your bad debt.
So we’ve established that bad debt is bad. And can be pretty awful for a business that relies on customers paying on time and consistently.
Bad debt stems from customers that cannot or will not pay, making the monies owed completely unrecoverable.
We established that bad debt will eventually surface in any business that provides goods or services on credit, it’s an unfortunate factor of being in this kind of business.
A reasonable business will accept that bad debt is likely to happen at some point in time, and will prepare for that accordingly.
We ran over a couple of ways in which you can prepare your business for bad debt.
The allowance method offers a proactive approach to bad debt. You use past data and good estimations to calculate a percentage of your sales that will become bad debt in a year. You then circle this revenue off, assuming it will become bad debt. Adjustments should be made comparing what you forecasted against what actually happened for your balance sheet at the end of the year.
The direct write-off method charges bad debt to the profit and loss as soon as it’s recognised. It’s a more reactive approach and whilst is arguably more accurate, you do need to keep on top of it and ensure it’s recorded accurately.
Ultimately, both methods are viable – the most important thing is to expect and manage your bad debt, especially if you want to get some of it written off at the end of the year!
Forecasting your bad debt will help you prepare for the worst, and if the worst happens we gave some simple steps for combatting that.