When you extend credit to a customer who fails to make good on their obligation to pay you, that loss of income becomes a bad debt. Most bad debt happens because a client has run into financial trouble. But regardless of the reason for it, a certain amount of loss is to be expected when you run a small business. So let’s take a look at how to deal with bad debt from a bookkeeping perspective.
How to Account for Bad Debt
Generally Accepted Accounting Principles (GAAP) tell us that every time we sell a product or service, the Revenue from that sale gets immediately recognized on our company’s Income Statement. This is true whether your customer pays on the spot (cash sale), or agrees to pay in the future (credit sale).
Credit sales form part of your Accounts Receivable. But if any of those receivable amounts become uncollectible, the revenue they represent – and that you’ve already reported – must be offset with a Bad Debt Expense.
Every business should allow and account for bad debt to keep their financial statements as accurate as possible. And the best way to accomplish that is with the provision or allowance method for dealing with bad debt.
The Provision Method for Bad Debt
Once it’s been determined that the money owed by a customer is uncollectible, some companies will use the direct write-off method to account for the loss. They do this by initiating a debit for the unpaid amount to their bad debt expense account, and a credit to their accounts receivable account.
But in GAAP accounting, an expense must be recognized at the same time an associated sales transaction takes place. So best bookkeeping practices dictate that we should use the provision method to better align the timing of expense recognition and recording of revenue.
Rather than waiting for a debt to become uncollectible, the provision method says we should debit an estimated amount to our bad debt expense account for a specific accounting period, and credit that same amount to the contra A/R account known as Allowance for Doubtful Accounts. This estimated amount represents a reserve or buffer against future uncollectable funds.
Allowance for Doubtful Accounts
When you use the provision method, your company assigns a dollar value to the percentage of credit sales it believes will likely manifest as bad debt. In other words, you don’t wait for a customer invoice or account to become uncollectible before you report it as an expense.
To arrive at this dollar estimate, you’ll need to evaluate your accounts receivable on a regular basis – monthly, quarterly, or annually. Then most companies will use their past experience and historical financial records to arrive at an approximate credit loss for the period.
Let’s consider that your company is showing $10,000 in accounts receivable, but your experience leads you to believe that 5% of that amount – or $500 - will ultimately become uncollectible. GAAP says you must report that estimated amount as bad debt for the accounting period in question. So your bookkeeping entry will reflect a debit of $500 to your bad debt expense account and a credit of $500 to your allowance for doubtful accounts.
Because the allowance for doubtful accounts is a contra A/R (asset) account, recording potential bad debt in this way reduces the net amount of accounts receivable showing on your Balance Sheet, like so:
Total Accounts Receivable = $10,000
Less: Allowance for Doubtful Accounts = $500
Net Accounts Receivable = $9,500
But this reduced (net) amount is NOT mirrored by your actual accounts receivable. It only appears on your balance sheet to better reflect the true state of your company’s assets at a given point in time.
Bad Debt Adjustments
The allowance your business makes for bad debt typically accumulates across accounting periods, but can also be adjusted as necessary.
For example, once you determine that a $100 client invoice has become uncollectible, you’ll reduce both your accounts receivable and your allowance for doubtful accounts with a $100 debit to the allowance account and a $100 credit to A/R. Because both accounts are being reduced by the same amount, there’s no change in the net accounts receivable amount showing on your balance sheet.
Your business reserves the right to collect amounts earmarked as bad debt at any time should circumstances change. You can also write off bad debt against your business taxes if the loss amount was previously reported as income on your annual return.