What Is Bad Debt in Business? Causes, Implications, and Solutions

Netflix has over 151 million paid subscribers.

The company began in the late 1990s, and they’ve experienced tremendous growth. You can bet that one of the reasons Netflix has risen to the top is because they use the best accounting practices around.

If a few million customers decide not to pay their bills, Netflix has a backup plan. They know all about dealing with bad debt. As a small business owner with big plans, you need to become an expert on unpaid invoices too.

Read on to learn the ins and outs of handling accounts receivable and how to set up the best allowance method.

Bad Debt Definition

First, what is the bad debt definition? When a small business owner has an account they can’t collect on, it becomes a bad business debt. This holds true for small businesses and large businesses alike.

Bad business debts can happen for a variety of reasons. However, sometimes poor bookkeeping or accounting practices are the cause of bad business debts.

Best Bookkeeping and Accounting Practices

If customers aren’t properly notified of their bills, you can hardly expect them to pay on time. Other accounting mistakes could involve poor communication methods, unclear invoices, and the list goes on.

If you’re noticing a lot of bad business debts within your company, it’s time to take a look at your payment processes. Review what your methods are for giving customers their invoices.

Then find out what type of system you have in place for following up with customers when the invoices go unpaid. While you don’t have to become an accountant, you should be well apprised of your company’s bookkeeping practices.

Power of Progress Billing

To avoid unpaid invoices in the first place, your company should look into progress billing. As you reach milestones with projects, you can bill clients incrementally.

Instead of sending clients a large lump sum invoice, they’ll be able to pay a little bit at a time. Progress billing does take a little bit more paperwork. However, as long as your company has access to get accounting software, it can be easy to set these plans up.

Progress bills are going to work best for large projects that you’re doing over a long time. You’ll be able to get an adequate level of funding to keep the project going without taking on too much risk. If the client doesn’t wind up paying for the entire project, you’ll still be able to collect on the unpaid portion.

Bad Business Debt Deduction Tips

Even with the best invoice collecting process in place, bad business debt will happen. There will always be accounts that you’re simply unable to collect on. Unfortunately, unpaid invoices are a part of the business world.

The good news is that you can look into deducting your bad business debt from your taxes. For example, if you have an unpaid invoice that you loaned out of your cash or included in your income, it would qualify as a tax-deductible bad business debt.

The IRS is also going to want you to prove that you’ve reported that income for the bad business debt on a previous tax return. They’re going to want to see that you’ve taken reasonable steps to resolve the unpaid invoice with your customer.

The Cost of Credit

If your company is extending credit to new or existing customers, bad business debt is more likely to occur. However, that doesn’t mean you should cut credit out of your business plan.

Instead, you’ll need to budget for the inevitable accounts that will not add up on your balance sheet. It’s called a provision for credit losses. You can also check out a Benefits Of Non Recourse Factoring option.

Plan on bad business debt being part of your business expenses. It’s one of the risks you take on when you extend credit to customers. To make sure everything adds up, your bad business debt expenses need to be estimated in a specific way.

Setting up an Allowance Method

Estimate all of your bad business debt expenses using an allowance method within the same exact period that the sale occurs. Let’s break that down for you.

If you want to record debt using the allowance method, you’ll be able to anticipate your future losses. To avoid any type of account overstatement, you’ll be able to estimate exactly how much of your receivables from your current sales period could be delinquent. Do you see where this is going?

Instead of looking at the annual sales period, you’ll need to keep things current. Set aside your current business budget for a bad business debt expense credit account. Over each sale period, allow the bad debit account to grow. Before you know it, you’ll have hefty savings to go towards unpaid invoices.

When Does It Become a Direct Write-off?

Before you write off your unpaid invoices, you’ll want to think ahead. Is there a possibility that this client could pay the invoice off in the future? If the likelihood is good, then you’d want to avoid deducting your bad business debt on your tax return.

There isn’t a specific number of days that make the invoice something you should instantly write off. The invoice doesn’t even technically have to be overdue for you to write it off.

Instead, what matters most is that you can prove that the invoice is completely worthless; it will not give your company any type of monetary gain. Consider your clients on a case-by-case basis. If you have a great customer management system, you can keep track of customers who consistently make late payments.

Handling Unpaid Invoices the Right Way

There’s no way around it; unpaid invoices can be a hurdle for any company. By being proactive, you can avoid bad debts and financial disasters.

Set up a budget today so that your company can prepare for unpaid invoices. Spend time reviewing your accounting practices too. Make sure you’re reaching out to clients in a way that works so that you can provide them with friendly reminders about their bills.

By taking the time to perfect the invoicing process, you’ll be setting your company up for success. We’d love to help you with more tips and tricks, so read another article!