How Being Prepared for Bad Debts can Improve Cash Flow Decisions

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One of the more unpleasant aspects of being a business owner is having to chase clients that do not pay.    It is frustrating, stressful and disheartening, while attempts to collect are an utterly unproductive use of time and can have a significant impact on cash flow, particularly if you are unprepared.

There are ways to mitigate the possibility and impact of bad debts.  Some of these include: 

  • Performing a Credit Check on Customers
  • Charging a retainer, which is paid up front
  • Offering discounts for early payments
  • Allowing several payment options including credit cards which allows for immediate payments
  • Following up on delinquent receivables dilligently.

Regardless of your efforts to prevent them, incurring bad debts is often inevitable and ultimately, a cost of doing business.  Consequently, it is important to ensure that you are prepared.

Designate an Amount:

Setting up a reserve for bad debts is an excellent way to prepare for them if and when they happen.  In accounting parlance this is referred to as an Allowance for Doubtful Accounts (somewhat self explanatory) or AFDA.  There are two ways to do this: you can designate a percentage of your accounts receivable as uncollectible based on experience or the quality of your accounts receivable.   The second way to do this is to periodically review your accounts receivable and determine which amounts due might not be collectible.  The total of these amounts will represent your bad debts.

Set up a Reserve:

Once the amount of bad debts has been calculated, you should reflect it on your books.  Since the bad debts are an expense it will reduce your net income for the period.  The corresponding credit will be applied to a separate account called Allowance for Doubtful Accounts which reduces your accounts receivable.  Technically speaking, you will debit bad debt expense and credit allowance for doubtful accounts.

How to Reflect AFDA and Bad Debts in Quickbooks:

  1. Set up a new Accounts Receivable accounts called Allowance for Doubtful Accounts
  2. Set up a new expense account called Bad Debts expense
  3. Set up a new Customer called AFDA
  4. Setup a new item called Bad Debts and select Bad Debts expense as the account.
  5. Create an invoice credit note for the estimated amount of the bad debts with AFDA as the customer and Bad Debts as the item.
  6. When specific customers are deemed uncollectible, write off the amounts by creating a credit note for the specific customer and select bad debt expense.
  7. Reduce your allowance either via a period end adjustment or create an invoice for the exact amount of the bad debt written off in #6 following the steps in #5.  Since the bad debt has already been provided for, this will not impact on your bottom line 

Monitor your Reserves:

Depending on the size and number of accounts receivables, you should review your bad debt expense regularly.   It helps to maintain a schedule which can be reviewed and updated.   

Cash Flow and Tax Implications:

  • It is important to reflect a reserve for bad debts in your cash flow forecasts and budget.  This will allow for you to contemplate other options in advance.
  • When specific bad debts are recorded in your books, make sure to reflect the sales tax impact. i.e. if your invoice included sales tax, make sure that it is reversed, so that you can recover sales taxes that were never actually received.
  • Reserves for bad debts (AFDA) or not actually tax deductible and need to be added back to net income when preparing your Federal tax return.  It is only when specific invoices are written off that they become deductible.

In a perfect world customers would pay their debts on time.  The unfortunate reality is that this does not always happen, for a variety of reasons, some uncontrollable.  Ensuring that you are prepared can help reduce stress and lead to better business decisions .