Most of us are used to exchanging money for goods and services. This makes transactions easy and prevents issues of debt collection. In most lines of business, however, credit is essential. We sell our products and services with the assumption that the customer will receive their invoice and promptly remit payment.

There are several advantages to offering credit to your buyers. First, you will open up your business to a wider market, as many prefer the sale/invoice/payment model. Second, you will incur occasional losses when your customers don’t follow through.

In accounting, a sale on credit that is not paid in a timely manner is known as a bad debt expense. Handling this issue carefully is essential to keeping your books and your business on track.

The Basics of Accounting for Bad Debts

In the accrual method of accounting, a sale is recorded as soon as it is made. When you make a $100 sale, you record $100 income. This then increases your revenue and net income. Whether and when the buyer pays is an issue between them and your billing department.

When a buyer then fails to pay, you must reduce the amount of revenue accordingly. In addition, you list these unpaid funds as a bad debts expense (or credit loss) on your income statement. These adjustments should be made as soon as possible, although the losses cannot be claimed and written off on taxes until a later date.

This may sound simple, because it is a very simplified version. In reality, the issue becomes much more complicated.

Assessing Credit Risk

One of the best ways to handle bad debts is to prevent them. This can be done by carefully assessing the credit risk of your customers.

A customer with bad credit already has a history of unpaid debts. This should be considered carefully before extending credit to them. You may not want to become yet another creditor whose calls they are ignoring.

Before giving a line of credit, do a thorough credit check. Some companies even ask for references. However, even with these checks and balances, occasional bad debts will occur. Some people experience sudden changes in financial resources and simply cannot pay.

Every company that sells on credit will eventually have credit losses. It is important to include bad debts as well as projected bad debts in your receivable accounts.

How Bad Debts Affect Accounts Receivable

When you first sold the item, you recorded the sale as income called accounts receivable. However, there is a good likelihood that a certain percentage of your clients simply will not pay up. This can become a problem because the income you are owed is reported as one of your assets, which means your income reports and company balance sheet are not accurate.

Business owners often have to supply documents such as income reports and balance sheets when they are applying for credit, when they are working with investors, and in their own tax accounting. It is important for these documents to paint as accurate a picture as possible, which means accounting for this lost income and projecting how much income will not be paid.

Dealing with Bad Debts Expense: The Allowance Method

Most companies account for bad debts using the Allowance Method. This involves estimating a dollar amount or a percentage of their accounts are not eventually paid. They then amend their income reports with a negative contra-asset amount that is called Allowance for Doubtful (or Uncollectible) Accounts. This allows an imprecise but more accurate financial picture.

This method is popular because you can complete your accounting and income report without needing to know exactly who will not pay nor the exact amount. It simply gives an estimate of how much income you will actually be receiving in the near future.

As you bring in more income, you will need to adjust your Allowance for Doubtful Accounts and subtract the additional projected bad debts from your income.

How do you decide on a percentage or a dollar amount for this method? If your company has been offering credit for a long enough period of time, you can simply project based upon your past. Otherwise, many people project conservatively, erring on the side of projecting more unpaid debt than they will likely have. Many people struggle with whether to choose a percentage or a firm dollar amount. A firm dollar amount is usually the simplest method because it does not require constant recalculation. You can easily add to it if your sales increase to the point where it is no longer enough.

Using this method, when a debt is not paid, you simply remove the amount from your Accounts Receivable and your Allowance for Doubtful Accounts. No further action is needed. If the debt is paid later, you can reverse both of these changes.

Dealing with Bad Debts Expense: The Direct Write-Off Method

Most companies use the allowance method in dealing with income reports and similar documents. However, the IRS requires a different type of calculation called the direct write-off method.

In this method, the company only reduces their account receivable when they know that the debt will not be collected from that customer. This can take several months and leaves your income artificially high in the intervening time, which is why investors and banks prefer the allowance method. The IRS, on the other hand, is invested in seeing your profits over-reported and your losses under-reported.

This method is also preferred by the IRS because it is very precise and deals only with information available right now, rather than projections. In addition, it is easy to fix your accounting if the situation changes. If a debt is somehow repaid after you have directly written it off, you can simply subtract the amount from your credit losses and add it to your income.

Which Method Should You Choose?

In an ideal world, accountants and business owners would choose the method that works best for them and stick with it. In the real world, this is usually not possible Using the allowance method is best practice in the world of business accounting. On the other hand, the IRS demands that you instead use direct write-off. Ultimately, most businesses will have to be familiar with both and use both on a regular basis.