Overview
We all strive to maximize our satisfaction and surround ourselves with the best and most practical things. This applies to the purchase of household appliances, accessories, and clothing. Yet, not everyone can afford to upgrade their wardrobe or buy a new phone for cash.
This is why loans and credit sales were invented. They are designed to make our life easier and enable us to buy a little more than we can afford right now. Today, it’s hard to surprise someone with an offer to take the goods now and pay for them later. Business owners also benefit from increased sales.
Giving credit encourages customers, however, a downside of giving credit is that some customers do not fulfill their obligations and pay back the money they owe. This is a necessary risk of doing business on a credit basis. Since the accounts receivable are presented in the accounting records of the organization as an asset, given the nature of the debt collection, the asset may not have any value.
In this regard, the best option for a company that sold on credit or a financial institution that gives loans is to look at it as a loss and write it off. Writing off these credit sales, though, is prohibited if such debt is current and not considered uncollectible. Overdue payments cannot be taken off the books as bad debt right away. Accordingly, it is kept in a doubtful debt account for some period of time. Bad debt is current receivables for which there is a confidence that the debtor is not going to return.
Why write off such uncollectible payments? Losses from writing off such accounts are subject to inclusion in non-operating expenses. Non-operating expenses directly affect the determination of the taxable income amount for calculation of the income tax payments, which ultimately affects the final tax amount a business would need to pay.
Writing off bad debt
Writing off credit sales that you cannot receive money from is an expense that is an inevitable part of doing business. First, let’s review the direct method of accounting for such situations.
When you write off the money you believe you are never going to receive, you reduce the Accounts receivable and balance that out with Bad debts expense. You would do this at the point in time that you identify the account as being uncollectible. In most cases, debtors who have not paid their debt in three months are not going to pay at all.
If payments should be made only in a different accounting period than the associated sale, then you will end up with an overstated profit because the income from the sale is not matched with the associated expense of these payments not being made. The profit in the next year will be understated. Moreover, the Accounts receivable will be overstated during the first period because it does not accurately reflect the funds your business will likely be able to receive from customers. How to write off bad debt to present the most accurate picture of your financials? To achieve this, business owners turn to an allowance method.
With this method, you are going to make an educated guess at the end of the first year about the portion of credit sales you made that will end up not being paid by the customers next year. You will obviously not be absolutely correct, but you are going to make your financial statements look more realistic. An Allowance for Doubtful accounts will serve as a bookkeeping account that you will use in this case to balance out the reduction in the receivables. Why do you need to use such an account?
No one knows for sure who will not pay their debt and how much debt in total will be uncollectible. Thus, you would use your previous years’ financial reports, industry average, and other relative data, such as an overall bad economic condition that might affect the customers’ ability to repay debt, to come up with the percentage of sales revenue you are not going to receive.
Bad Debt Deductions
When you want a get a tax deduction for the bad debt, there are certain criteria it has to meet before you can do that.
- First of all, this has to be a bona fine debt. There should be a specific agreement between you and the debtor about the debt repayment amount and timeline.
- Next, you look at whether the debt has become worthless, in whole or in part. There are numerous things to consider when looking at the facts and circumstances that show the debt has gone bad. For example, a debtor’s insolvency or bankruptcy, lack of assets, persistent refusals to repay, ill health, death, and other factors can point to debt gone bad.
- In addition, this obviously has to be a business debt as you cannot deduct personal or investment debt on your business tax form.
As you can see, business owners need to know not only how to write off bad debt, but also how to deduct it for tax purposes
