Every business will suffer from a bad debt at some point in its life and this short guide will show you how to account for them in your business.
A bad debt is where a customer does not pay you for work done. That could be for many reasons:
- Refuses to pay
- Disputes your invoice
- Ignores your demands
The question is, at what point does an invoice become a bad debt? If you had agreed terms with your customer of, say, 30 days. Then is it a bad debt on day 31? No. It just means you are suffering the same problem as countless businesses around the world: and that is a bad paying customer.
So is it after, say, 60 days. No again. The time is actually irrelevant. It tells you nothing about your customer’s ability or willingness to pay. And that brings me to a subject 90% of small businesses don’t bother to do: Terms and Conditions.
It is imperative that you set out your terms and conditions and ensure your customer agrees to them. Don’t be tempted to copy someone elses. If it contains ‘legalese’ any judge worth his salt will throw it out of court. Terms and Conditions represent a contract between you and your customer. Make it plain and simple.
Spell out very clearly that all invoices are due within 30 days of the invoice date (or whatever your terms are). Say specifically that if the invoice is not paid by 30 days you will charge interest at the rate of 5% a month (or whatever percentage and period you feel comfortable with). Explain that if the invoice is not paid within 60 days you will persue them in the courts. I realise this can seem off putting to a customer, but we are talking about your time and money versus the possibility of not being paid at all.
There is nothing wrong with writing the above in a pleasant style. That is just good business, but you must spell it out and mean what you say. You will get respect for it. And if you don’t, ask yourself if that customer is really worth the gamble.
OK. So at what point does an unpaid invoice become a bad debt? The simplest way to tell is when you get a letter from an administrator explaining that the customer has gone into receivership or administration. You now have proof that something is amiss. It is still not a bad debt though. That is because there is still a chance the business could be saved.
But what if you don’t get a letter? Well, most countries have conditions set by their Inland Revenue services to protect you and let you write off a bad debt after a certain time period. At the time of writing in the UK for example, I believe it is 6 months. Just check with your Inland Revenue service.
Right, so you now have proof or can legally write off the debt. What do you do? Simple. Open a new expense account called ‘Bad Debts’. Enter a journal From Debtors To Bad Debts. In double-entry you Debit Bad Debts and Credit Debtors.
If you want to learn a much faster way to understand double-entry and get your debits and credits sorted properly, sign up for our bookkeeping course. It has helped thousands already.