What are bad debts?

Bad debts are basically bad news. Here, we look at how they occur, how to account for them and steps to try and avoid them. Every business will at some time or another experience a bad debt. The following article provides you with an overview of bad debts.

A bad debt: Explanation

The amount owed for goods or services, supplied on credit, ends up as a bad debt write off due to non-payment by the customer. In most cases, this occurs when a customer has money troubles and ends up the subject of insolvency proceedings like administration or liquidation. Many businesses supplying a customer in this situation will find out about it when they receive a letter from the appointed insolvency practitioner (IP), explaining the situation and requesting confirmation and proof of the debt owed. This scenario is pretty much the end of the road as far as the amount owed is concerned. The chances of getting 100% of the debt back is unlikely, and unsecured suppliers can only hope for a small dividend payment once that the IP has realised any value in the bust of the customer’s remaining assets.

Adjusting the books

From an accounting angle, there is a couple of things that should be done both from a principle perspective and also as a money saving exercise. The amount of the debt should be removed from the customer's account so that it appears on the profit and loss account as an expense. This will have the effect of reducing profit, but at the same time will reduce any year-end tax liability. By doing this, it will also reduce the debtor figure on the balance sheet, ensuring that the asset position is not overstated. Businesses can also salvage some of the debt by reclaiming VAT. If the original invoice included VAT and the amount has been paid to HMRC, then debt relief is available.

Keep them to a minimum

Businesses can go a long way to reducing bad debts by having a good credit management system in place. Knowing who the customer is before goods are supplied, and being confident that they can pay is fundamental. Once that the debt is there, it is very important to keep on top of it and ensure that it’s paid when due with regular contact and reminders. If it becomes clear that a customer has cashflow problems, then requesting instalment payments will at least reduce the total amount. By being proactive, there is a good chance that a business can avoid doubtful debts becoming bad ones. The secret is to know all about a customer’s financial issues well before the IP’s letter arrives, because by that time, it’s a little too late.