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what is the best way to record a bad debt? — Business Ready

what is the best way to record a bad debt?


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General & AdminIn a perfect world customers would pay their invoices in full and on time. Unfortunately not every customer is perfect and, despite even the most air-tight credit policy, a start-up will have to learn some of the accounting rules behind bad debts and the meaning of Days Sales Outstanding (DSO).

Last week I was asked one of the most confusing accounting questions for new entrepreneurs:

What is the difference between a bad debt and an allowance for doubtful accounts?

The primary difference is that bad debt is an expense account whereas the allowance for doubtful accounts (”AFDA”) is a balance sheet account, a contra-account to offset the accounts receivable balance.

The concept of an allowance, or reserve, is based on the matching principle, one of the sacred accounting principles of GAAP, as well as conservatism. The matching principle ensures that expenses are recognized when the associated revenue is recognized. By using the AFDA, a bad debt expense is recorded in the same period as when the revenue was earned.

The general purpose of the reserve is to ensure that readers of your balance sheet are not misled. For example, if your accounts receivable balance at year-end shows $100,000 but you know that an outstanding invoice for $20,000 may never be collected, the assets on your balance sheet may be overstated by $20,000.

In order to ensure that your accounts receivable are reported correctly, each outstanding receivable should be reviewed at year-end. Traditionally, companies used an estimated percentage of the total A/R balance to calculate the allowance for doutbful accounts. However, in order to avoid the misuse of estimates to manipulate earnings, companies should specifically identify which accounts are doubtful and provide a list of the invoices at risk for non-payment.

Let’s follow an example of the customer who is unwilling or unable to pay your $20,000 invoice. On the day your invoice is recorded, you would record the following journal entry:

Dr Accounts receivable ……………………………. 20,000
Cr Revenue ……………………………………………………………. 20,000

At year-end, the invoice is over 90 days old and remains outstanding. Based on your attempts to collect or negotiate with the customer, it is no longer safe to assume that this invoice will be collected and so it must be flagged as doubtful.

Dr Bad debt expense ………………………………. 20,000
Cr Allowance for doubtful accounts ………………………….. 20,000

After every attempt has been made to collect, the decision is made to write off the invoice. This could be months, or even years, after the invoice was originally issued. The invoice should now be removed from the listing of accounts receivable and the AFDA will be reduced accordingly.

Dr Allowance for doubtful accounts …………. 20,000
Cr Accounts Receivable …………………………………………… 20,000

Of course, the best way to avoid a bad debt is to collect payment at the time of purchase or in advance of services rendered. If your business requires you to extend credit to customers, make sure that each new customer is reviewed and granted credit only after a full credit check has been performed. Stay on top of your outstanding receivables and identify potential issues early in the collection process. It’s easier to resolve an issue if the transaction is recent and both parties are still willing to negotiate.

If you haven’t documented your company’s procedures regarding interest on overdue receivables, bad debts and AFDA, be sure to download the Business Ready Allowance for Doubtful Accounts template and customize it to match your company’s policies.

If you want to avoid any kind of bad debt there can be absolutely NO allowance for procrastination in your invoicing and collections process. Now that you understand how to record a bad debt, remember that CASH IS KING. Pick up the phone and collect those outstanding invoices!

6 comments ↓

#1
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Mohamed
on 05.03.09 at 12:08 pm

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very nice explanation for this confusing accounting case

#2
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Tanya Burek
on 05.04.09 at 12:15 am

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Thanks Mohamed, it’s a question I hear from clients on a regular basis!

#3
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norm
on 12.11.09 at 1:49 pm

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I understand the AFDA, however we currently record the actual write off and take a hit to AFDA. For example, $5000 bad debt plus $5000 AFDA for total bad debt of $10,000. There is some disagreement as to the accuracy of this method.

#4
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Ahmed
on 05.18.11 at 9:42 pm

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That’s such a great explanation. I want to know what If the customer wanted to pay back the invoice or part of it after recording bad debts or AFDA How can we record the transactions then ?

#5
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Hussain
on 11.19.11 at 3:00 pm

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In reference of the above example If a customer fails to pay the invoice amount of 20000, we record the bad debt of 20000 but actually in 20000 our profit was also included so the actual bad debt should be the actual cost of the Invoice. please advice

#6
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Mark Robinson
on 05.20.14 at 3:29 am

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Very well explained but I have also question about debt. How should deals with the debt collectors ? if they are misbehaving and threatening that they will sue you. Do they really can sue us? or We have other options to deal with them?

Any advice please thanks

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