Bad Debt and Uncollectible Accounts
Bad debt is money that cannot be collected by financial institutions and is classified as a loss. This usually happens when the debtor, whether an individual borrower or business, declares bankruptcy. Other reasons include lack of cash flow and poor management. Most businesses sell their goods on credit in order to increase their sales volume. They usually make sales to trustworthy or regular customers, but some of their clients have fair credit. Failure to make payment on the part of such customers is a source of financial stress. Other reasons why customers fail to pay are disputes over terms and conditions, delivery, supply, quality of the goods or services, etc.
In simple words, bad debt is accounts receivable that are written off because they are uncollectible. It costs businesses money and makes accounting more complicated. Most companies use accrual-based accounting whereby expenses and revenues are recorded when they occur. Sales that are not paid become overdue accounts and are written off as bad debt. However, overdue accounts may remain unnoticed due to different collection procedures that companies have.
Bad debt refers to notes receivable and accounts receivable that are uncollectible. It is reported as uncollectible accounts or bad debts expense on the income statement. Accountants use either the direct write-off method or the allowance method.
Bad debt may refer to a portfolio of loans or a loan that a financial institution considers uncollectible. A personal loan that comes with a high interest rate is considered bad debt in personal finance. Banks make profit by charging interest rates on credit cards, loans, and other financial products. They charge taxes, fees, late payment fees, etc. If a client fails to make timely payments, the bank assesses late charges. The client risks ending up with bad debt while the bank makes a profit in the form of late payment charges. Many people have loan, mortgage, and credit card payments to make, and the situation can spiral out of control. This is when an outstanding obligation can become bad debt, and borrowers turn to debt counseling and debt consolidation.
Companies usually send an invoice, and if the customer pays, the amount is recorded as revenue on the income sheet. If the client fails to pay, the company sends a past due invoice in an attempt to collect the payment. Some companies use the services of a collection agency or a lawyer for this. Once the company has exhausted all efforts, it is time to clear the balance. The method is different for accrual basis and cash basis accounting. Given that it is not likely that all bad debts will be collected, many businesses have a debt allowance.
Ways to Avoid Bad Debt
Encourage slow payers to make payments. Some companies use invoices with boxes like “90 days” and “60 days”. These send a message to customers that the company is willing to act as a creditor, especially if invoices are marked as “payable upon request”. Rather than this, specify a date, on which the invoice is due, e.g. 25 December, 2012. People are less likely to pay attention to your invoice if it says “90 days”. One way to encourage prompt payment is to offer a small discount if the invoice is paid within 7 – 10 days. For example, you can offer a discount of 2 – 5 percent. Collection of payment is the main reason to issue invoices. Including promotional offers with your invoices is a good way to encourage customers to pay and to attract more clients. You can print something like “We offer 5 percent off if you bring this invoice with you within 10 days”. Make sure you specify a date in your invoice promotion. Another idea is to send a coupon together with your invoice. This method works great for promoting services and products that are on sale, e.g. specials and buy one, get one free type of promotions. There are other ways to attract customers and ensure prompt payment. Some companies offer bring-a-friend discounts. This is a way to make use of promotion opportunities, increase your customer base, and avoid bad debt.
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