Our step-to-step guide to calculating your bad debt
Jun 15, 2022
Selling goods/services and getting paid for them is at the core of any business. Yet in these troubled economic times, there is no certainty regarding when you’ll get paid by your clients. If ever.
Past a certain point, your unpaid invoices are considered bad debt - they’re uncollectible. Accumulating too much bad debt puts your whole business at risk. In some cases, you might even declare bankruptcy.
Because uncollectible accounts threaten your cash flow, it is important to keep an eye on them.
So, what is the best way to calculate and track bad debt?
How can you avoid bad debt in the first place?
We answer these questions in this guide, so keep reading!
Pssst! Upflow allows you to automate your receivable process to get paid more easily and faster. Eliminate your bad debt and focus on planning for your growth instead.
What Is Bad Debt and Why is it Important to Track?
What is Bad Debt (or Doubtful Accounts)?
Bad debt is invoices that never get paid. The services/products have been delivered, the invoices sent, but the payment never came.
After a while, the invoice in question is deemed uncollectible and written off as bad debt. Bad debts are also called doubtful debts, or doubtful accounts since the business doubts the fact the invoice will ever get paid.
It happens when a business allows credit sales, like Net 15 or Net 30 payments. Sometimes, the client cannot or does not want to pay their invoice.
Why is Tracking Bad Debt Important for Your Business?
Bad debt can threaten your company’s liquidity. It is money from sales you were planning on receiving but never did. And you obviously need income to keep the business afloat. Tracking it ensures that your liquidity or sustainability isn’t challenged.
It also measures the success of your accounts receivable process. With optimized billing and invoices processes, bad debt happens very rarely. If you have accumulated bad debts, it might be time to review your receivable process.
Last but not least, calculating and tracking your bad debt means being able to balance your books. Bad debt is concretely written off as an expense in your general ledger. They come up as operational costs on your income statement, which means you won’t pay any taxes on net income you never earned.
How do you Calculate Bad Debt?
There are several ways to calculate bad debt:
The Direct Write-off Method.
The write-off method is the most straightforward way to calculate and report your bad debt. It means simply manually recording your bad debt as an expense, as they occur.
At the end of the year, you calculate how much bad debt you wrote off - that’s it! You can compare your total with the previous years and see if there is a variation.
It’s best used if a few bad debts occur in your business, as manually processing those can take some time. As a small business, you might want to consider this option if you don’t do a lot of credit sales.
The Allowance Method.
Creating a Bad Debt Reserve.
If your business uses credit sales as its main sales method or has to write off debt regularly, it’s best to use the allowance method.
Concretely, it means planning ahead by writing off a percentage of your total credit sales as bad debt. In other words, it is budgeting bad debt as an operational expense.
When bad debt does occur, you can subtract it from this bad debt account to buffer your losses.
Following the matching principle, bad debt needs to be recorded during the same accounting period as your credit sale occurred. It allows you to balance the liabilities bad debts represent on your balance sheet.
If you decide to use the allowance method, there are two ways you can calculate your projected bad debt:
Percentage of Bad Debt.
To calculate your allowance, you first need to calculate your bad debt rate, which is based on your past experiences.
% of Bad Debt = Total Bad Debts / Total Credit Sales (or Total Accounts Receivable).
Once you have your result, you can project it onto your current credit sales. So if your bad debt rate was 2%, you can move 2% of your current credit sales into your bad debt allowance. We’ll see later how exactly to report that.
The Account Receivable Aging Method.
Another way to know how much to plan for your bad debt reserve is to use the aging method.
To do so, you need to have your aging report at hand. They show you where your invoices stand in different categories:
0 to 30 days overdue,
31 to 60 days,
61 to 90 days,
It’s a great way to visualize where your accounts receivable are piling up. You can then attribute a percentage of bad debt to each of these categories.
As a rule, the longer it hasn’t been paid, the slimmer the chances of an invoice ever getting paid. For example, you’d put 1% bad debt to your 0 to 30 days category, and 30% past 90 days.
Calculate what amount of your accounts receivable it represents in each category and add them to get your total bad debts. That’s your projected bad debt, whose amount you can now allocate to your allowance account.
How to Record Bad Debt Expenses.
When to Record Bad Debt.
When does an account receivable turn into bad debt? There are several elements to this question:
Bad debt only happens in accrual accounting.
Based on the GAAP (Generally Accepted Account Principles), accrual accounting records transactions when they are rendered.
If your client agrees to an invoice, it is recorded by your company right away as an income - regardless of whether it has actually been paid or not.
When an invoice needs to be written off, it, therefore, has to come off as an expense on your financial statements to be accurate.
In cash-based accounting (the opposite of accrual accounting), transactions are recorded when cash leaves or lands on your company’s accounts. So when an invoice isn’t paid, there is nothing to record or undo. Technically, nothing ever happened.
What the IRS says on bad debt.
According to the IRS, an unpaid invoice can only be written off as a bad debt when there isn't a chance the amount due will be paid. In order to do that, you have to be able to demonstrate you’ve taken reasonable steps to collect the debt.
That’s why payment reminders are key in your account receivable process and especially in recognizing bad debts.
When to record bad debt for your business.
Practically, you are the one who decides when exactly to record bad debt in your business. Depending on your main sales method (cash or credit) and credit policy, a different timing will make sense. Do remember the matching principle if you are using the allowance method.
Recording Bad Debt Using the Write-Off Method.
To record bad debt using the write-off method, you simply have to make a journal entry on your balance sheet.
A debit from your bad debt expense account.
A credit to your accounts receivable.
While this method records the precise amount that needs to be written off, it doesn’t respect the matching principles of the GAAP.
Recording Bad Debt Using the Allowance Method.
If you want to use the allowance method, you have to record your bad debt differently. For this, you’ll use a contra asset account to use as an account allowance for doubtful accounts.
This account is linked to your accounts receivable account on your balance sheet - it’s part of your liabilities. It also includes a third line that reflects the net amount you hope to collect.
To record your bad debts, you debit the bad debt expense account and credit your allowance for the bad debts account.
Let’s say that based on your projected amount of bad debt, you want to allocate $10,000 to your allowance account. It will look like this:
Now let’s imagine that sometime later, a client tells you they won’t be able to pay the $2,000 they owe you. You’ve offered solutions, even a repayment plan, but they won’t budge. So you decide to write their invoice off your accounts receivable.
Since you have an allowance account, you’ll be able to absorb this loss, but you need to record this as bad debt. Your journal entry will look like this:
Improving your Accounts Receivable to Avoid Bad Debt.
Now you know all about bad debt and how to record it, let’s look at ways you can minimize it. In a nutshell, it’s all about being proactive about your accounts receivable.
Optimizing Your Payment Process.
By optimizing your payment process we mean your billing, invoicing, and receivable processes. While it may sound daunting, there are a few actions you can take today to make it happen.
Have Clear Payment and Credit Policies.
Knowing exactly which terms you offer to your clients is key. Team up with your sales team to know what clients are asking as payment terms, and come up with specific terms together. You can create different ones for small business and corporate accounts.
If that doesn’t sound achievable, you can set up a process where an account manager has to get your validation before agreeing to different payment terms with a client.
If you’ve decided to lower your credit balance as a way to reduce bad debt, it wouldn’t make sense for your sales team to keep selling at credit. Anything is possible as long as your company is on the same page.
Make it easy for clients to pay you.
While making it easy for clients to pay you entails enticing payment terms, it’s not the end-all-be-all when it comes to accounts receivable.
Another way you can get paid faster is to make it really easy for your clients to do the actual payment. That looks like this:
Sending your invoices before/on their due date, including all the relevant information like your payment terms.
Including various payment methods. Some customers might prefer paying via bank transfer, whereas others will prefer to do so with a credit card. Include payment links and specific instructions.
Offering a smooth experience. From receiving their invoice to paying it shouldn’t take more than a few minutes. Make sure you use user-friendly software.
Being Proactive with Your Late Invoices.
The above is mainly applicable before the invoice due date and should already get you paid faster. You can also go a step further in the receivable process and tackle your invoices that are already late.
Setting up Receivable Processes.
By that we mean: any internal process that makes your and your team’s jobs easier. You can come up with a process that makes sense for your company and bookkeeping specificities. What’s important is to actually have a method, and to follow through with it.
For example, you can:
Set up reminders to follow-up on your A/R (and encourage your team to do the same),
Attribute specific tasks to specific people, so everyone knows what to do,
Schedule regular meetings to check-in on your results.
It will allow your team to follow through with your unpaid invoices efficiently. When everyone is crystal clear on what needs to be done, when and by who, everything runs smoothly.
Sending Payment Reminders.
Sometimes, your client just forgets to pay you. It happens. To counter that - or prevent it from happening altogether - you can send payment reminders.
You can use emails, SMS, letters, and even try calling (it’s very 1990s, but it works). By following up with your clients, you show them that getting paid is a priority for you. So it becomes a priority for them.
You can do so manually, but at Upflow we prefer automating repetitive tasks. That’s why our A/R tool allows you to send automated (and personalized!) emails to your customers.
You can even set up different workflows with different emails based on your customer segments (late payers, corporate accounts, etc.)
Need help sending effective email reminders? Have a look at our free templates!
Using Automation to Improve your A/R.
There are a lot of tedious and repetitive tasks that are involved in collecting your receivables:
Sending follow-up emails,
Checking individual invoice amounts,
Checking your receivable balance,
Ensuring individual payment terms are respected,
Automation makes all of this more efficient, so you can focus on what really matters: preventing bad debt. By freeing your time, you can focus on the accounts that need your attention the most.
Upflow also makes payment and communication easier for your clients. Instead of giving you the silent treatment, they can for example raise a dispute over an invoice in a few clicks from their dashboard.
With advanced analytics, A/R software like Upflow helps you stir your company’s boat in the right direction. That makes your financial reporting easier, too.
Bad debt is an accounting write-off of unpaid invoices. It’s an assumption that these invoices will never get paid, and falls under the operational costs of running a business.
It’s important to calculate your bad debt because it endangers your liquidity. Ultimately, if too many clients don’t pay, it jeopardizes your business.
There are several ways to calculate bad debt. You can sum up the manual write-offs you did during an accounting period, or use projected models like the bad debt rate and the aging method.
In order to be compliant with the GAAP, you need to report your bad debt using the allowance method. It is a projection of your possible bad debt amount that is allocated to a specific account. It will help buffer any future loss.
To prevent bad debt from happening in the first place, you need to be proactive in your accounts receivable process. You can do so by optimizing your payment processes, sending payment reminders, and using automation.
Upflow is an A/R software that helps you prevent bad debt. It allows you to be more efficient in your collectible process, so you can focus on the accounts and tasks that matter most.