Bad debt is the term given when customers or clients either can’t or won’t pay. But how do businesses end up with bad debt?
Many businesses use credit terms – usually requesting payment within 30 days of receiving the goods or services. When offering such terms, recording the sale is important as it increases the turnover of the business. But it is also important to make provision for doubtful debt to ensure any non-payment reduces tax liabilities.
This simply means you are making an allowance, as a percentage, for debts that are considered doubtful. The doubtful debt provision should be included on the company’s balance sheet to give an overview of its financial health.
While most customers or clients will pay within the agreed time, there are times when payment isn’t made within the agreed terms. Most business owners then make a call or send a letter regarding the outstanding amount, which leads to payment.
Sometimes, however, the payment isn’t made despite the business chasing up with calls or letters – eventually this becomes ‘bad debt’.
There are a number of ways that a business can be affected: either the customer won’t pay or they can’t.
- Won’t pay
A customer might argue the goods or services provided are not satisfactory. As a result, they refuse to make payment. Legal action against the customer or client maybe considered, but it is expensive and could cost more than the outstanding payment. As a result, it might be sensible to write off the bad debt.
- Can’t pay
Companies that provide business to business supplies or services might also face non-payment due to a client’s insolvency. A recent report shows the number of UK companies declaring insolvency is rising, so there is a chance that more businesses will end up with unpaid invoices. While receivers will try to pay a portion of the outstanding invoices, all too often there isn’t any money left to pay them.
Writing it off
If a customer or client can’t or won’t pay, the debt needs writing off. As the sale has already been recorded and turnover increased, the turnover must be removed. The debt also needs taking off the customer ledger to show they no longer need chasing for payment.
Record the amount as an expense rather than reducing sales. This is carried out because the sale took place and the goods and services were provided, they were just not paid for.
Create an account called ‘bad debts’, which is recorded in the expense section of the profit and loss report. The account is debited to reflect the increased expense account. Next, the sales ledger control (also known as ‘debtors’) should be credited. This is carried out because the amount owed by the customer is reducing and the asset is also reducing.
If VAT was charged when the sale was made, it needs removing. Once this is done, debit the VAT account to reduce liability.
Bad debts are, sadly, part and parcel of life when running a business. If you need help understanding how to record bad debt, then contact our team for help.