Bad debt is an irrecoverable receivable – a type of expense that occurs when a customer to whom you have extended credit is no longer able or willing to pay you. In accounting terms, this is known as a “bad debt expense” which must be charged against your company's accounts receivable.
Consequently, because the bad debt expense reduces the value of the accounts receivable on your company’s income statement, bad debt affects your financial projections and cash flow. In addition, the financial harm can spread to other businesses in your ecosystem as well.
In most cases, the reason is simple: your customer simply cannot pay the bill due to insolvency or bankruptcy.
Your customers may be experiencing delays in payment themselves. They may be enduring supply chain problems that are slowing down deliveries of components they need to manufacture the goods they sell.
Your customer’s bank credit line may have been withdrawn, curtailing his or her operating capital. The market may have turned down suddenly, impacting sales and the overall business model.
It could also be that you’ve extended credit to an unsuitable customer. If this is the case, you should tighten up your credit control policy to prevent it from happening in the future.
Bad debt can also be the result of credit fraud, in which your business has been deliberately targeted by criminals, or a customer misrepresented himself in obtaining a sale on credit from your company and has no intention of ever paying you.
Keep in mind that the first sign your receivables are in danger of becoming a bad debt is late payments of invoices.
It’s important to classify bad debts as such so that investors can see that all your accounts are in good order.
But remember: the manner in which you record bad debt expenses will differ depending on the country you’re based in. For example, most businesses based in the UK use international financial reporting standards (IFRS), while much of the rest of the world uses generally accepted accounting practices (GAAP).
There are two main ways to record a bad debt in accounting: bad debt write-off and bad debt provision.
A bad debt provision or allowance is an accounting method that requires you to estimate the amount of bad debt that you expect to write off in any given period.
In brief, you charge an estimated amount of accounts receivable to bad debt expense, before debiting the bad debt expense for the estimated amount of the write-off. Finally, you’ll credit the same amount to the bad debt provision contra account.
In most cases, you can reclaim tax paid on bad debts; and it’s a form of bad debt relief applied to both accounts receivable and accounts payable.
This is applicable when you have already accounted for VAT but your customer defaults on full or partial payment. Specific criteria and conditions differ from country to country, but in general tax authorities allow companies to claim back the already paid output tax on bad debts.
If your company receives payment of a part of the debt, an adjustment for the bad debt relief already claimed must be made.
This form of debt relief is applicable when a customer defaults payment (in full or part) to your company for any supply of goods or services at the end of a specific period, and you have initially credited or refunded the relevant input tax. Your customer must reverse the input tax related to the defaulted payment as output tax, and the relevant tax amount must be paid back to the tax authorities.
If bad debt relief is paid, your company adjusts by reducing the VAT on purchases for the period in which the debt relief payment is received.
There are measures you can take within your company. Be sure your internal procedures include sound credit management policies and monitor your customers' and partners' financial management as well.
This procedure can be instrumental in avoiding expensive legal measures. If your customer misses a payment deadline, chase the outstanding invoice quickly: send a bad debt letter to try to collect the late payment and prevent it from becoming a bad debt.
The debt collection letter should be succinct, written on your company letterhead, include your signature, and suggest how to resolve the matter in a timely fashion. Learn more by reading our article on how to collect late payments, that includes tips to write bad debt letters.
Remember: you don’t want to alienate your customer. Find a balance between firmly insisting on the matter being resolved and the need to maintain a positive customer relationship.
Debt collection requires a great deal of expertise that some companies do not have. Commercial law, for example, is often complex and varies greatly from one country to another. To help you, do not hesitate to check our country risk reports that give you information on how to manage these local risks and practices effectively.
When you add to the time and money you will spend trying to collect a bad debt, it becomes clear that overdue debts cost more than the face value of the bill.
Forewarned is forearmed. A significant bulwark is bad debt insurance – also known as non-payment insurance or trade credit insurance: if your customer fails to pay you, your insurer compensates your company and protects your cash flow.
Reduce Non-Payment Risk with Trade Credit Insurance
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Allianz Trade is the global leader in trade credit insurance and credit management, offering tailored solutions to mitigate the risks associated with bad debt, thereby ensuring the financial stability of businesses. Our products and services help companies with risk management, cash flow management, accounts receivables protection, surety bonds, and e-commerce credit insurance ensuring the financial resilience for our client’s businesses. Our expertise in risk mitigation and finance positions us as trusted advisors, enabling businesses aspiring for global success to expand into international markets with confidence.
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