How to Record a Settlement of Debt in QuickBooks

We all fall behind on our bills at one point or another, but some may go a little further than that. 

Forgoing vendor payments for an extended period may add up to an insurmountable debt.

The debt may become a liability, which will require you to record a debt settlement in QuickBooks to help keep your books balanced. 

The Scenario

Unfortunately, your company, ABC, has been unable to pay back XYZ for a $1,000 monthly advertising bill that has now accumulated to $12,000.  

XYZ wants their money, and ABC knows its cash flow doesn’t warrant paying XYZ $12,000 for the past-due advertising bills.

A year has passed, and those 12 bills still sitting in your accounts payable continue to show as past due. You have a phone call with XYZ, and an agreement is reached…

The Debt is Forgiven

The best-case scenario for your business is that XYZ tells your company that those 12 bills totaling $12,000 on your books do not need to be paid.

So, how do we clear out my accounts payable in QuickBooks and show the twelve bills as paid?

Simple. Because XYZ has told you that those twelve are no longer due, you've now just technically generated a new source of income.

To record this transaction, you:

1.  Create a vendor credit for $12,000 to XYZ by clicking on New in the top left corner of the screen and selecting Vendor Credit under the Vendors section.

   
2. Enter the Vendor's name and the date (I suggest using the date the debt was forgiven), and create an “Other Income” account called “Gain From Relief of Debt” or something similar.  
3. Open Vendor XYZ and select any bill the vendor said does not need to be paid.
4. In the top right corner of the bill, click on the box "Mark as paid."
5. A new screen pops up, showing all unpaid bills and balances, as well as the credit you created.
6. Select all the bills the vendor is forgiving and the credit so the Amount to Credit balance at the bottom shows $0.

You have now recorded $12,000 in other income on your books used to settle your outstanding debt.

No Debt is Forgiven

The opposite of the above is that XYZ still wants their money in full, but they’ve opted for a payment plan. XYZ will accept $400 a month for three years to pay off the total debt of $12,000 interest-free.

The bills in accounts payable must now be converted to a liability. To do this, we will duplicate most of the same steps as above:

1. Create a vendor credit for $12,000 to XYZ by clicking on New in the top left corner of the screen and selecting Vendor Credit under the Vendors section.

2. This time, we will create a liability account that could be called “XYZ Debt Settlement” as the account on the credit.

3. Now, apply the credit to the unpaid bills by opening one of them and clicking on the "Mark as paid" button at the top right corner of the screen.

4. Select all the unpaid bills being converted to the liability and the credit so the Amount to Credit balance at the bottom shows $0.

Now, when you run a balance sheet, the Accounts Payable balance will be reduced by $12,000, and the balance will be held in the new liability account, "XYZ Debt Settlement."

A monthly payment will be made to XYZ and coded to the “XYZ Debt Settlement” account for three years until the balance is $0.

A Hybrid of the Two

A frequent scenario I see is that XYZ will agree to a lesser portion of the debt so long as an agreement is made for the debt to be paid off on time.

If a debt settlement company acts as a liaison between ABC and XYZ to broker a deal, they often charge ABC a fee, but the savings can, for the most part, be well worth the cost.

Let's say the debt settlement company brokers a deal with XYZ and tells you that they have settled for ABC to pay only $6,000. That sounds good!

The terms are that the debt must be paid off in one year, and the settlement company will charge a $100 monthly fee, thus requiring XYZ to make a monthly payment of $600.

Here’s the breakdown…

1. Again, create a credit for $12,000 to clear out the bills in accounts payable.
2. Split the credit amount between two accounts:
   1. $6,000 coded to an other income account called “Gain From Settlement of Debt.”

   2. $6,000 coded to a liability account called “XYZ Debt Settlement.”

3. Apply the credit to the unpaid bills by opening one of the unpaid bills and clicking on the "Mark as paid" button in the top right corner of the screen.

4. You now have a liability of $6,000 and an additional income of $6,000.

For one year, $600 will be paid monthly to the settlement company acting as ABC's liaison.

Those payments should be split to record $100 to a Professional Fees expense (for the settlement company fees) and $500 to the liability account “XYZ Debt Settlement.”