Author: John Rampton / Source: Entrepreneur In a perfect world, you would be paid for the goods or services that you have provided to a c
In a perfect world, you would be paid for the goods or services that you have provided to a customer or client — each and every time you provide them. Unfortunately, we don’t live in such a world and there are times when a receivable is not collected – even after you’ve attempted to collect the debt.
What do you do when you realize that the debt will never be paid? Besides being frustrating, bad debt has serious detrimental consequences for both your cash flow and accounting records.
“It is necessary to write off a bad debt when the related customer invoice is considered to be uncollectible,” writes Steven Bragg for Accounting Tools. “Otherwise, a business will carry inordinately high accounts receivable balance that overstates a number of outstanding customer invoices that will eventually be converted into cash.”
Writing off a bad debt
According to the Accounting Coach, Harold Averkamp (CPA, MBA), there are two methods for computing the amount of bad debts expense; direct debt write-off and allowance method. The direct write-off method would require a customer’s, “uncollectible account be first identified and then removed from the account Accounts Receivable. This method is required for U.S. income taxes and results in a debit to Bad Debts Expense and a credit to Accounts Receivable for the amount that is written off.”
The allowance method, however, “anticipates that some of the accounts receivable will not be collected. In other words, prior to knowing exactly which customers or clients will not be paying, the company will debit Bad Debts Expense and will credit Allowance for Doubtful Accounts for an estimated, anticipated amount.”
Averkamp adds that the allowance method is the preferred option since, “1) the balance sheet will be reporting a more realistic amount that will be collected from the company’s accounts receivable, and 2) the bad debts expense will be reported on the income statement closer to the time of the related credit sales.”
However, if you plan on deducting the bad debt, then you must use the direct write-off method. Keep in mind that once you decide that you’re going to write-off the debt you need to stop contacting the customer. Once it’s in the books, it’s gone.
Bad debt tax deduction
Due’s Miranda Marquit says that “if you are owed money from a business transaction, and have been unable to collect, you might be able to write it off as a bad debt. The