The saying used to be “Cash is King”. In today’s economy, a better phrase is “Credit is King”. Extending credit to your customers can encourage loyalty, repeat business, and expedited sales. However, extending credit isn’t risk-free. If a customer fails to pay, you need to write it off as a bad debt.
But what should you do if you suspect a customer won’t pay, but you aren’t sure? In this scenario, you have what is termed a doubtful debt. Let’s take a closer look at doubtful debt, how to allow for it, and how to manage your books as it becomes a bad debt.
Let’s start with bad debt. When you know a customer will not pay the amount due, it is bad debt, and you have to write off a loss. Doubtful debt is when you anticipate a debt becoming bad debt. In effect, the debt is in limbo – you can’t write it off as you might reclaim some of the debt, but then again, you might not.
Accounting for doubtful debt is useful. You can limit the amount of accounts receivable you report and give a clearer picture of your overall finances. Theoretically, if you account for doubtful debt early, you can better predict your revenue and write-offs.
However, remember you can only account for doubtful debt. You cannot write it off. The Australian Taxation Office (ATO) only allows deductions for actual uncollectable debt, not possible debt.
If you account for doubtful debt, at what point does it become actual bad debt? Any debt is only considered a bad debt once you have tried all means of recovering the debt and still failed to do so. You should be able to demonstrate you have exhausted all options available to you for recovering the money. Debt does not become a bad debt simply because it is overdue!
In accrual-based accounting, you plan which lines of your accounts receivable could become bad debts and set aside a relevant sum. This sum is known as a provision for bad debt, bad debt reserve, or an allowance for doubtful accounts. Providing for bad debt in this way creates a contra asset account. That is an account with a credit balance, and it offsets your accounts receivable to reflect the actual value.
The amount in the bad debt reserve represents the accounts receivable amount a company expects to write off. This is a useful accounting tool for managing company earnings, but how much cash should you keep in your bad debt reserve? An easy and standard method is to refer to past accounts. If historical company data shows that roughly 8% of sales per annum are uncollectible, then it would be sensible to set aside 8% in your reserve immediately.
You can reduce your reliance on doubtful debt accounting by improving your credit control. It may mean fewer sales, but you can be confident those sales will be paid for. Credit control focuses on strategies to improve the payment of invoices and reduce days outstanding and bad debts.
A business can use three main strategies to improve payment turn around, reduce the need for doubtful debt and ultimately reduce bad debt.
Doubtful debt is a useful accounting tool that helps to give a clear picture of your companies financial situation. However, it is better to focus on ways to reduce your business’s reliance on doubtful debt accounting by better credit management.