What You Need to Know About Bad Debt Expense for Business
Lost sales opportunities, bad debtor reputations, and high payment processing fees are some potential consequences of handling unprofitable clients. Learn how to protect your business from bad debt expenses and stop struggling with inefficiencies in cash flow management.
What is Bad Debt Expense?
Bad debt expense is the cost of goods or services that a customer has failed to pay for. It is a term used in the context of customer credit risk, which encompasses a variety of actions and tactics used to assess and manage the credit risk a business faces.
The term bad debt is used to describe a variety of defaulted accounts. Bad debt can be a “small business” customer who has not paid a bill, a customer who has not paid the last bill issued or the entire account receivable balance, or a large corporate customer who defaulted on an invoice.
Is It an Expense?
Bad debt expense is actually a cost that a company pays for the products and services it provides to a customer. The payment for the good or service is expected to be made at the time of the transaction.
The expense is recognized when a company determines that the collection of an account receivable is not probable. If a company decides that it will not be able to collect an amount due, it is considered an uncollectible amount.
What's the Difference Between Direct Write-Off Method and Allowance Method?
The direct write-off method is a more straightforward accounting method used to account for uncollectible accounts. Under this method, an amount is directly written off based on an account’s aging, without creating an allowance for uncollectible accounts.
The allowance method is more detailed and requires a credit loss allowance account, which is an expense account. Companies that use this method must then allocate the credit loss expense among accounts based on their relative exposure to uncollectible accounts.
The allowance method can be used with or without the allowance for doubtful accounts assets. The allowance for doubtful accounts assets is the portion of the allowance that is specifically identified by an account’s aging.
How Bad Debts Affect Businesses Today
Bad debts can occur with any business, but they are more common in industries that often deal with large, one-time purchases. These industries include the automotive industry and healthcare.
The effect of bad debt expense is often magnified when a company has to make a significant purchase, such as a car or house, that is financed. Large purchases often require that the customer borrow money, so many do not have the cash for the entire purchase in hand.
Bad debt expenses can take on many forms. Common bad debt expense scenarios are:
A customer has paid the invoice, but the check bounced.
A customer has paid only the minimum due.
A customer has never paid an invoice.
A customer has paid for the services or goods it received, but a portion of the payment was lost in the transaction.
A customer has been paid, but only after a collections agency has intervened.
Some businesses handle bad debts by informing customers that if their payments are late, they will be sent to a collections agency for additional fees. While this usually works, the firm may be better served by understanding why its customers are late.
Counterintuitively, bad debt expense may result in overspending. This occurs when a customer has paid the invoice in full but was charged a late fee. The customer may still be so angry that they refuse to do business with the company in the future.
Bad debt expense also affects a company's reputation. A company that allows its customers to run up large balances without payment may be perceived as an irresponsible and unreliable business.
Customers often Google companies before they buy to see if the company has a good reputation. If a company has a reputation for not collecting its debts, it will lose potential customers.
The Bottomline
A bad debt expense can hurt a company’s cash flow and reputation. These effects can be minimized through effective management of customer credit risk.
Totally Booked offers small business bookkeeping services in New York. Let us streamline the financial side of your business. We will handle all aspects of bookkeeping. Get in touch with us.