Bad Debt Expense
Bad Debt Expense | ConsolidationNow
When you have finally given up trying to collect an outstanding debt (usually it’s as an accounts receivable) and choose to take it off your company’s account it is necessary to make an expense. This is referred to as an bad debt expense.
If you’re in business with credit–i.e. give your customers terms for payment such as Net 30 or Net 15–eventually you’ll encounter customers who are either unable to or won’t pay.
If the money your customers owe to you turns impossible to collect and you don’t have the money to pay it, we refer to that as a “bad debt (or the term “doubtful” debt).
In this article, we’ll explain the specifics of bad debt costs, where to locate the information on financial reports, how to estimate your bad debt, and how to track the correct amount of bad debt in your accounting.
What is a bad credit expense?
An expense for bad debt is a financial transaction recorded in your accounting to reflect any outstanding debts your company has given up on.
It is only necessary to record expenses for bad debts when you employ an accrual-based accounting principles. However, bad debts remain a problem even if you apply cash accounting principles. However, since you didn’t record the debt as revenue at all. There isn’t any income to “reverse” with the expense of bad debt.
In the event of bad debt, you must ensure that your accounts reflect the reality of your business , and that your company’s net income isn’t appearing to be more than it really is.
The accuracy of recording bad debt expenses is essential if you wish to reduce your tax burden and avoid paying taxes on earnings you haven’t earned.
How do you find the bad debt expense?
As with the other expense accounts it is possible to find your bad debt costs within the overall ledger.
These expenses are categorized as operating expenses which you will generally be able to find them on your business’ income statement under selling, general and administrative expenses (SG&A).
How can I determine the cost of bad debt?
There are two methods to estimate your company’s bad debts. One is by directly taking your receivables off of your books or using an the allowance technique.
How do you directly eliminate your receivables from your account?
If you do not have many unpaid debts, they’ll probably be written off on a case-by-case basis once it becomes apparent that the client isn’t or will not pay.
In this case, it is a matter of recording an expense for bad debt on your general ledger, equal to the value of your accounts receivable (see below for the steps to create an expense journal for bad debt entry).
How can you tell if it’s the right time to write an uncollectible debt as non-collectible?
Following IRS, according to IRS, you should only be able to write off a debt when there’s “no more chance that the amount due will get paid.” You have to prove your ability to verify that your company has “taken the necessary steps to recover this amount owed.
” When you’ve attempted (and were unsuccessful) to reach out to the debtor via phone or to set up a repayment arrangement, then it could be the right time to pay off the debt.
How can you determine the cost of bad debt using the allowance method?
If you conduct many business transactions on credit, it is possible to record the bad debts you have in advance of time with this allowance method.
This is the process of establishing the allowance to cover unpaid debts (also known as a bad debt reserve or the budget for doubtful accounts). This is a pot of funds in your account that you draw out for “pay” to cover all bad debts that you’ll eventually be liable for.
The majority of businesses set up their allowance for bad debts with a proportion of good debts.
What is the percent of the bad debt formula?
Because you’ve established it in advance, the amount you have allocated for bad debts is always an estimation.
The process of estimating your bad debts generally will require a percentage formula for bad debt, which is simply the number of your bad debts in the past multiplied by the number of your previous credit sales.
Percentage of bad credit = total bad debts or total credit sales
Let’s suppose you’ve been in the business for a year, and out of the $300,000 of credit sales you had in the first year, only 20% of them were uncollectable.
You’d like to create an account for unpaid debts to transfer these bad debts to the report before. How large will the allowance be?
In the beginning, you’ll determine your share of debts that are not paid:
Percentage of bad debt = $20,000/ $300,000
The percentage of debt that is bad = 6.67 percent
If 6.67 percent seems like a reasonable estimate for the future of uncollectible accounts, you should then make an account for uncollectible debt equal to 6.67 percent of the projected credit sales.
If you had $50,000 in credit transactions in January on the 30th of January, you could get to record an adjustment entry in your allowance for bad debts accounts to record $3,335.
However, it’s not always a reliable way of predicting future bad debts, particularly if you’re in business for long or if a single bad debt alters the amount of bad debt you have.
How do you keep track of a bad loan expense?
There are two instances where you can write off a bad debt expense in your financial records by writing off the account receivables you’ve decided are uncollectible or in the case of establishing a reserve for bad debts.
Recording the cost of a bad debt using the direct write-off technique
Let’s say that your business, XYZ Inc., is looking to immediately erase an account worth $800 receivable that you feel is no longer worth collecting. After making contact with the customer one more time and receiving their phone machine
Recording an expense from a bad loan for the allowance method
Let’s say, after calculating your company’s percent in bad debts (see above), and You’ve set up an account for bad loans of $2,000 on your books at the close of the current month.
Your account of bad debts will be a counter-asset balance this means it will be listed on your balance sheet and all other assets accounts.
Now imagine that, within a couple of weeks, you have a customer who informs you that they won’t be in a position to pay the $200 they owe you, and you’d like to take the credit card for $200.
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