Record and calculate bad debts
If you offer products or services before they are paid for, it is sometimes possible to record bad debts. This happens when you issue an invoice, but your customer doesn’t pay it. There are two distinct ways to manage bad debts on your books and it’s important to have a clear understanding of both strategies. In many cases, you can claim a bad debt deduction on your tax return.
By using the direct write-off method, you can simply subtract bad debts from your accounts receivable. For example, suppose you send an invoice for $2,000 to a customer. The customer goes bankrupt and cannot pay. Therefore, you must subtract the invoiced amount from your accounts receivable.
This method is the simplest, and if you use cash accounting, you can use the direct write-off method when tracking unpaid invoices. However, if you use accrual accounting and wish to conform to general accounting principles, you should use the accrual method to write off bad debts.
The provisioning method allows you to anticipate bad debts before they occur. Using this method, you can create an allowance for bad debts or an account for expenses related to bad debts. The allowance for bad debts is a fixed amount that you expect to lose each year. It is a permanent account that appears on the balance sheet and represents funds already recorded in accounts receivable, but which you believe will turn into bad debts.
On the other hand, expenses related to bad debts constitute an expense account. You determine the percentage of invoices that will potentially remain unpaid and you contribute a percentage of the amount of each sale to the expense account related to bad debts. This account does not appear in the balance sheet, and it is reset to zero at the end of the year. However, using a bad debt expense account is a great way to tie potential bad debts to sales.
Recording bad debts using the accrual method
To explain the process, let’s assume you are a fruit vendor. You sell 15 baskets of bananas to a local grocery store and issue an invoice for $100. However, the store goes bankrupt and does not pay the bill.
As you have already recorded the $100 in your accounts receivable, now you need to eliminate them. And because you use double-entry bookkeeping, you must record a credit of $100 in your accounts receivable and a debit of $100 in your allowance for bad debts or in the expense column related to bad debts.
Since your accounts receivable are recorded as debit, the credit decreases the balance in this category. This reflects the fact that you now have a lower amount of overdue invoices. Adding the debit in the other column keeps the books balanced by keeping the net value of these two accounts.
If you have bad debt, you can deduct it as a business expense on line 8590 of Form T2125. To claim this deduction, you may have already reported the unpaid bill as income on a previous year’s return.