Understanding bad debt and what you can do about it
Even if you’ve never heard the term “bad debt”, you’ve probably had experience with it. Have you ever loaned money to a friend or family member, and never been repaid? What about paying for a product or service you didn’t receive, and couldn’t get reimbursed for? Although most people don’t use the term “bad debt” for these types of personal experiences, that’s exactly what the business equivalent is called.
Bad debt is a debt that your business is unable to collect on. Since you can’t collect on this debt, it is rendered worthless. The IRS has a specific set of regulations governing bad debt, in terms of how to account for it for tax purposes. For example, businesses may only write off bad debts that have previously been recorded as income. Sales on credit and loans to customers or vendors may be considered bad debt, but rent, salaries and other fees may not.
It’s pretty obvious how you might end up with bad debt in your personal life. But what about your business? Bad debt is one of the perils of doing business on credit, as defaulting on credit is often the culprit. But it’s a risk many are willing to take, as an overwhelming number of companies sell products and services on credit. And there are a lot of steps you can take to late payers into receivables before resorting to bad debt.
One of the key IRS provisions regarding bad debt is that you must demonstrate reasonable attempts to collect on the debt. This is an exercise you should be going through anyway as you attempt to collect payments from customers, so all you have to do is document that exercise. It can be as simple as sending regular invoice reminders, or complex options like offering customers payment plans or sending demand letters (where appropriate).
If your own collection attempts fail, there are multiple ways to use outside parties to help with the collection process. Invoice factoring & financing and collection agencies are all on the table, depending on how much you want to spend to collect on outstanding invoices. The costs of these services vary depending on how much risk is taken on by the outside party.
Once you’ve exhausted your own internal efforts to collect and weighed the cost of outside efforts against lost income, it’s time to determine your total amount of bad debt. Accounting and invoicing programs should offer an easy way to generate an itemized list of bad debt. You can pull a bad debt report in Invoiced, which tells you which invoices were closed before being paid in full.
Now you have an understanding of your business’s bad debt. Next up: decide how to categorize it. There are two ways to write off bad debt: as a direct write-off or an allowance. The direct write-off method is similar to itemizing on your personal taxes. Each bad debt is recognized as as it is deemed uncollectible. The allowance method, also called allowance for doubtful accounts, is similar to taking the standard deduction on your personal tax return. The allowance for doubtful accounts expects that some accounts receivable for any given period will be lost. The bad debts estimate is made in the period that same revenue would be recognized.
Let’s face it: bad debt is a side effect of widely-available credit. There are steps you can take to minimize it, but you probably can’t avoid it entirely. The most important thing you can do is implement payment structures that increase your likelihood of getting paid, and manage bad debts as exceptions.