Because you can't know in advance the amount of bad debt you'll incur, learn how to make an allowance for potential debts.
How you account for your bad debts will depend upon whether you use the cash basis or the accrual basis of accounting. If you use the cash basis, you recognize income only when a payment is received. Bad debts are not a problem because you simply never record the income that you were expecting to get.
If, like most businesses, you use the accrual method, the process is a little more complicated. It's complicated because you actually accrue a bad debt when you sell your goods or services on credit to a customer who does not pay you. You must recognize the income from the sale at that time, but you won't know that the customer did not pay until you've exhausted all of your collection alternatives. Since this can take a year or more to determine, you often won't know that a past-due account is a bad debt until a later tax year. Thus, you may be in the position of recognizing (and paying tax on) income that you never actually receive, and not knowing this until a later tax year.
Why does a bad debt accrue when the goods are sold? Well, you offer credit primarily to increase sales. You are willing to accept the risk that a few customers might not pay you, in order to gain sales from customers who simply need more time to pay. In order to accurately determine your costs of doing business over a given period of time, you have to match your accrued bad debts during the period against the sales they help generate.
- Allowance for bad debts: If you're going to match the bad debts against the sales when the bad debts accrued, you'll have to guess at the amount since you won't know the actual amount until much later. This guess or estimate is called an allowance for bad debts.
- Bad debt recoveries: In rare cases, you'll write off a debt as uncollectible only to have the customer pay it after you've already written it off. If that happens, you'll have to adjust your accounts for what you had already written off as uncollectible. The process of accounting for it is called a bad debt recovery.
Allowance for bad debts
The purpose of making an allowance for bad debts is to try to guess the total amount of bad debts that you're likely to incur during the tax year. You do this by calculating the bad debts as a percentage of your sales.
But which percentage should you use? If you've been in business for a few years, you can look at your own experiences to determine a percentage. Take a look at this example:
Example: The ABC Company has been in business for three years. In those three years, it has experienced the following:
| Sales | Bad debts | % of sales | |
| Year 1 | $16,000 | $480 | 3.0 |
| Year 2 | $22,000 | $120 | 0.5 |
| Year 3 | $26,000 | $360 | 1.38 |
| Totals | $64,000 | $960 | 1.5 |
In year 4, the ABC Company should use 1.6 percent as its bad debt allowance.
If you're just starting out, you'll just have to make a guess. Start out with something around 1.5 percent or 2 percent, and adjust it in the following years as your actual experience dictates.
Estimating your bad debt amount and accounting for bad debt recoveries
In a few rare cases, you might have a customer pay his debt after you've given up on it and written it off. It happens. If it does, you'll have to make some general journal entries to reflect the payment. Hey, there are worse things that could happen than having to account for the fact that someone unexpectedly gave you money.
For example, say that on December 31 you had written off Roderick Spode's $50 account as uncollectible. Suppose that good ole Roderick comes into some money and decides to pay you off in full on January 20. Your journal entries might look like this:
| Debit | Credit | ||
| Jan. 20 | Accounts Receivable-Roderick Spode | 50.00 | |
| Allowance for Doubtful Accounts | 50.00 | ||
| To reinstate the account of Roderick Spode written off on May 2. | |||
| Jan. 20 | Cash | 50.00 | |
| Accounts Receivable-Roderick Spode | 50.00 | ||
These entries have the effect of increasing your cash accounts by $50 and decreasing your allowance for doubtful accounts by the same amount.
What if the customer were to pay only part of what he owed? What if he paid only $25? If that happens, you have a judgment call to make. If you believe he will pay all of it back, you may want to go ahead and make the accounting entries as if he had paid the amount in full. If you do not believe he will pay it all back, you should make entries to reflect only that he has paid you $25.