Getting stuck in a bad debt situation can be taxing. However, it is important that you "write off" your bad debts. Writing off a bad debt simply means that you are acknowledging that a loss has occurred. This is in contrast with bad debt expenses, which is a way of anticipating future losses.
Accounting for bad debts is important during your bookkeeping sessions. The tax rules applying to you can sometimes change depending on how much bad debt you have raked up. The guide below will help you write off any business bad debts that may have been haunting you recently:
What is Bad Debt?
Bad debt is a dangerous concept that can cause you to lose out on money that is rightfully yours. In essence, bad debt is when someone owes you money, but the money owed becomes null and void. As a result, you cannot collect your original invoiced/loaned amount and end up with a deficit in your own assets.
Anyone can accumulate bad debt, be it an individual or a business. Bad debt cannot be collected but should be tallied within your finance books and gross income records.
How to Write Off a Bad Debt
Getting stuck in bad debt can complicate your tax situation and bookkeeping sessions. Recognizing these losses by writing them off is crucial for accurate financial records and potential tax benefits. There are two key methods to formally write off business bad debts that you can't collect:
- Direct write-off method
- Provision method
The Direct Write-off Method focuses on eliminating uncollectible accounts as they are identified, offering a straightforward approach. Meanwhile, the Provision Method is more proactive, as it involves setting aside reserves for potential bad debts. For a nuanced understanding of these methodologies and their implications for your business, read on.
DIRECT WRITE OFF METHOD:
In this method, the seller of a product (the purchasing price of which was not fully paid by the consumer) will add the debt amount to their bad debt expense account. The bad debt deduction is done once it is confirmed that the consumer will not pay back their debt.
This amount is a debit to the bad debt expense account and a credit to the accounts receivable account.
In this method, the seller charges the original unpaid invoice amount to their allowance for doubtful accounts. Some people also call this the "allowance method."
This amount is a debit to the allowance for doubtful accounts and a credit to the outstanding accounts receivable account.
More on the Direct Write Off Method
Following the rules laid down by the direct write off method, you will have to report any bad debts on your income statement regardless of whether you are doing so as an individual or on behalf of a small business or company. This is done when the customer who caused you the bad debt's account is finally written off.
This typically happens months after the credit sales was generated. Writing-offs can be a long and winding process, so it's important to keep yourself updated with any advancements in a certain ex consumer's bad debt case.
As the person responsible for handling this bad debt, it is your responsibility to enter the loss into your Bad Debts Expense book and credit it to your Accounts Receivable.
In the direct write off method, there is no contra asset account (Allowance for Doubtful Accounts book). As a result, everything in the Account Receivable book will be counted as a current asset on the company or individual's balance sheet.
Stemming from this, the balance sheet may end up reporting a value that is higher than the amount said individual or company is actually going to end up collecting. This can create disturbances in the overall accounting process, so professional accounting firms do not prefer using the direct write off method.
Provision or Allowance Method
This is the second method used by accountants to write off a bad debt that has resulted from a company or individual that sold goods based on credit but never received any payment for it, not will they receive a payment in the future.
Under the allowance or provision method, the individual mentioned above or company will record an adjusting entry at the end of every accounting period for the number of losses anticipated due to credit extension towards their customers.
This type of entry will include the operating expense account (Bad Debts Expense) as well as the contra-asset account (Allowance for Doubtful Accounts)
In the future, when a specific account receivable is finally written off as "uncollectable," the individual or company's account debits Allowance for Doubtful Accounts and credits the Accounts Receivable.
Professional accountants prefer employing this method over the direct write off method for a number of important reasons:
- The income statement will account for the bad debts expense nearer to the time the sale or service was granted.
- The sales balance sheet will report a more realistic net amount of account receivable that will eventually be converted into actual cash and be credited to the individual or company's account.
This method of bad debt write-offs can be applied in the following ways:
- You can focus on the bad debt expense that is needed on the income statement.
- You can focus on the balance needed in Allowance for Doubtful Accounts; this will be reported on the balance sheet.
As you can see, there are two prominent methods one can employ when attempting to write off bad debt. The first method, the direct write-off, is simpler but not appreciated as often.
Hence, even though it is slightly more complicated, it's better if you opt for the second method, provision for doubtful debts, to get a more accurate representation of your final financial gains. If you need any help with this, reach out to the experts at Hall Accounting Company to guide you through this process.