Bad Debts: Analyzing Them and Writing Them Off

It's a situation every small business owner dreads: a customer doesn't pay. But it happens.

I'm going to cross over into managing your business for a moment, because before I show you how to record bad debts in your books, I want to make sure that you have done everything you can to minimize them. There are some strategies that you should implement in your everyday management practices that will help.

Screen your customers

If you are selling large-ticket items or large-dollar services, do not grant automatic credit to everyone who comes in the door. It's a recipe for disaster. Screen your credit customers thoroughly. You can (with their permission) obtain a credit agency report showing any past credit problems. You can also have them fill out an application and ask for supplier references. Make sure to call the references. Some businesses do not grant credit until the second or a later sale. Whatever you do, make sure you know enough about your new customers before you grant them credit.

Set credit limits

Giving your customers unlimited credit can leave your company vulnerable. It is far too easy for businesses operating in good faith to get in over their heads with credit. Some unscrupulous businesses search for suppliers with lax credit limits, then stockpile product. They run up a huge bill and never pay. You have little leverage at that point because they don't need anything else from you: you've already given it to them. Setting reasonable credit limits can help you avoid some of those problems.

Make your credit terms clear

Ensure that you have your terms on every invoice and statement that you produce. When you take on new customers, make sure you go over your policies with them. Sometimes, this simple step can help you avoid major misunderstandings.

Follow up with monthly statements

As described above, make sure that you send out monthly statements of account to your customers. Frequently, this simple reminder can produce results.

Call your customers when they are overdue

Don't be afraid to call your customers about overdue invoices. It ranks right up there with a root canal, but the old saying "The squeaky wheel gets the grease" applies here. Be consistent in your communication to your customers, and they will appreciate your businesslike attitude.

Get professional help

When all else fails, and you are pretty sure you have lost the customer anyway, turn the account over to a collection agency. Agencies will usually charge you a percentage of the amount they collect, but it is well worth it not to have to lose sleep over harassing the customer for money.

Pursue the debt in small claims court

Every jurisdiction has different rules for which matters can be brought to small claims court and what the procedures are for doing so. If you feel that you have a strong case and the customer has money to pay the bill (there's no point trying to get blood out of a stone), you may wish to pursue this option. If the judge rules for you, the customer will have a judgment against him or her ordering payment to be made to you. If the customer still doesn't pay, he or she will face repercussions from the court.

Writing off the debt

If you finally get to the point where you think there is no hope (either the customer has skipped the country or gone bankrupt), it is time for you to write off the account.

The accounting entry is as follows:

DR Bad debt expense

DR Sales tax liability

CR Accounts receivable

This action removes the invoices from the accounts receivable balance and records the expense on the income statement. You must do this because the income was recorded in the income statement when the sale was made. When it becomes uncollectible, the net income should be reduced accordingly. The entry also removes the amount that you have posted as owing to the government for sales taxes. You won't get the money now, so you certainly do not need to give it to the government.