Uncollectible accounts are one of the biggest nightmares for self-employed and SMEs. For this reason, it is recommended that preventive measures be taken -such as making a provision for accounts, contracting policies against non-payment- before they occur as reactive – insistently claiming the debt, going to collection companies- once we intuit that delinquency can become entrenched.
What is an uncollectible account?
An uncollectible account is a payment not received from an invoice in which you extended credit to the customer for the sale of your products or services. You will not always charge for your work or your products in cash or cash, and it is common to establish payment terms so that your clients can pay your invoices.
We are faced with a bad debt when your business has already used all the ‘cartridges’ to recover the debt, but no results have been obtained for 180 days. These ‘cartridges’ are mainly the claim channels and the extrajudicial negotiation with the debtor company. The uncollectible was considered an active debt within the term established for its cancellation. Now it is a delinquent debt, and in your accounting, it will be reflected as losses for all tax purposes.
The loss of uncollectible accounts
When an account is deemed uncollectible, as the name suggests, you don’t expect the debt to be satisfied. When it stops qualifying as an asset, you must remove it from your accounts as such. It is a loss of support and a decrease in your income. Therefore, you have to record it as the expense of an uncollectible account.
Uncollectible accounts are also harmful because, in addition to making all these adjustments in your accounting, you lose energy looking for how to minimize the tax burden according to current laws and regulations. For example, how to recover VAT on unpaid invoices.
Although you learn from everything terrible: they will make you estimate a provision to cover the uncollectible accounts of an exercise. The important thing will be to recognize this loss in your financial statements and anticipate that it will always occur, to a greater or lesser extent.
How to calculate the provision or reserve for doubtful accounts?
There are three methods:
- Immediate cancellation: uncollectible accounts are of a small amount, and you settle that balance directly. It is not a method that can be abused because it generates inconsistencies between expenses and income of the period the accounts correspond.
- Calculation: part of classifying your accounts according to their age and analyzing them to determine an estimated percentage of uncollectible funds. This method does not oppose the terrible debt loss to the income that produced it, nor does it allow you to determine a realistic percentage of bad debts for each year based on your income.
- Estimation: the provision for doubtful accounts receivable is estimated based on a certain percentage of current accounts receivable. Although it does not fit the concept of opposing expenses and income, it is considered the most efficient because it allows you to determine the money to reserve for bad debts in the current year.
For example, when preparing the financial statements for the week, your experience tells you that 0.5% of your invoices will never be collected. Then, you can use a percentage of credit sales method so that your business automatically charges 0.5% of credit sales each week in bad debt expenses, crediting it to the allowance for doubtful accounts. In the current week, you are going to sell €10,000 on credit: what you have to do is calculate the bad debt expense of those sales (for this example, €50) and record the entry:
Ways to avoid bad debts
- Evaluate the creditworthiness of your clients and establish appropriate credit limits
- Prepare clear payment terms and conditions, expose them on your website, in your budgets and invoices, and be strict with them.
- Send your bills on time and start chasing payments days before due.
- Talk to your customer when they are late on a payment and try to resolve any disputes as soon as possible by establishing billing dispute criteria.
- Do not extend credits to customers who have not yet paid you.
- Impose late fees
- Offer discounts to customers who pay on time
- Implement other debt collection procedures to manage unpaid accounts, such as Bulldoc’s legal protection insurance for professionals and SMEs.