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What is a Business Bad Debt?
From a business perspective, bad debt happens when a customer's debt becomes uncollectable. Most small business owners are aware of the customers that pay their bills and the ones that don't. This is because a relationship almost always exists between the small business owner and the customer.
But you don't need to have a strong relationship with your customer in order to tell if he or she is paying his bill. If you have an accounts receivable, then your bookkeeping software should have an aging report available.The aging report lets you know how long your receivables have been outstanding.
It's important to stay on top of collection efforts with your customers. This could involve a courtesy call followed by a letter or e-mail. However, such communication should never be rude or abusive. While it is frustrating to lose hard-earned money, approaching debt collection the wrong way could have negative legal ramifications. Besides, it's just not good practice to lose your temper. Even a customer who defaults on a bill is one that can spread good or bad word of mouth about your business.
Once you've made reasonable effort to collect a debt and you determine that it's uncollectable, it's time to consider whether you'll forgive the debt or seek an alternative solution.
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How Do You Forgive Debt?
There are two main components to a business forgiveness of bad debt. For bookkeeping purposes, the bad debt is recorded as an expense called bad debt expense. Different methods for writing off bad debt exist; however, most businesses use the allowance method for bookkeeping purposes. This method allows the company to anticipate what the bad debt will be each period and write it off in the books. The allowance method follows Generally Accepted Accounting Principles (GAAP).
The account called allowance for doubtful accounts is a contra account in the asset section of the balance sheet. This means that rather than having a positive balance like its counterpart, accounts receivable, it has a negative balance. The journal entry for this allocation is to debit the bad debt expense account and credit allowance for doubtful accounts. These accounts should be reviewed periodically in case they need adjustments. To learn more about the allowance method read Ciel S. Canoria's article Allowance for Doubtful Accounts: Examples and Explanation.
However, the IRS does not allow a business to use the allowance method for tax purposes. Rather, a company must use the direct write-off method when preparing taxes. The journal entry for the direct write-off method is to debit the bad debt expense account and credit accounts receiveable. In the direct write-off method, debts are written off when a specific customer's receivable has become uncollectable. There is no guess work in this method.
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Consider the Alternatives...
Alternatives to forgiving debt do exist. Business owners can take their customers to small claims court. However, it is important to determine whether or not the cost is worth the effort. Some businesses, such as retail, have a certain amount of bad debt that is considered to be a normal part of operating expenses.
Other businesses will sell their accounts receivable. The terms are usually with or without recourse. With recourse means that the small business retains responsibility for the collectibility of the accounts.
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Photo Credit: freedigitalphotos.net, renjith krishnan
Resource: Based on the writer's experience in the field.