Bad debt is an amount of credit owed by a debtor that is unlikely to be paid back. It is commonly a result of the debtor going bankrupt, or their business going into liquidation. As this credit cannot be collected, it is then worthless to the creditor and has no worth to the lending organisation. It is often the case that pursuing the debt proves more costly than the original amount of credit. Once this debt is considered to be bad, it will be written off by the business as an expense. This type of debt can end up forming a large part of the expenses for a business.
Management of bad debts
Proving the business relationship
There must be documented evidence of a business relationship between the company and the customer or client to which the debt applies. For example, the company must be able to provide receipts, invoices and written contracts, plus any other documentation such as order placements and confirmation of transactions. Correspondence pertaining to terms and conditions of the signed contract will also help to bolster the evidence for proving the debtor has neglected their financial obligations. Ideally, all of this information should be gathered in order to prove a breakdown in the business relationship.
Showing uncollectable status
The debt then needs to be proved as uncollectable. This is harder than proving a business relationship, as it requires the company to provide documentation that shows there is no chance whatsoever of the debt being paid off. This will need to include documented evidence of attempts to collect the debt. This should include phone records, emails, copies of letters or notices and any legal action taken to pursue the customer.
Proving a financial loss to the business
In order to prove a loss to the company as a result of bad debt, daily detailed records of transactions and amounts will help to build evidence. The time and date of each sale also needs to be recorded. This continuous process is known as accrual accounting. This method involves recording income at the time of the actual sale or service. This form of close monitoring is the safest and simplest way of highlighting the debt.
This then needs to be written off in the same financial year that it becomes uncollectable. This is to ensure that the bad debt can be separated from the cost it took to provide the good or service. It then needs to be removed from the stated business income once it has been written off. As a result, the stated income and status of all transactions will remain accurate. As a working example, the Internal Revenue Service (IRS) in the U.S. requires bad debts to be written off in the same year that they are deemed uncollectable. In contrast, it is typically written off after six years in the UK.
Tax deductible debt
Some bad debts are tax deductible. Therefore it is possible to claim unpaid funds as a tax deduction. In order to begin claiming debt as a tax deduction, a company must first ascertain whether the debt forms part of the ‘assessable income’. Using the accrual accounting method, a company can count the income when the invoice is issued, as opposed to waiting for the payment to be received.
Following on from this, a company must have made reasonable attempts to recover the debt. The effort should ideally equate with the amount of debt being recovered. For example, a letter or a phone call to follow up on a sum of two or three hundred pounds will be considered as a reasonable attempt. For debt equating to tens of thousands of pounds, legal action would need to be taken before the debt is declared as bad.
The debt has to be written off to be tax deductible. The amount has to be recorded, including information on when the invoice was delivered. It is also possible to claim a deduction on a debt that has been partially written off. Debts owed by related parties such as family members, business partners or shareholders are not tax deductible.
Avoiding a bad debt write off & bad debts
Checking credit worthiness
There are certain steps that companies can take to mitigate the risk of running into bad debt when dealing with a customer or client. Some of the most common steps for avoiding it begin with checking that the customer or business is credit worthy. They must have consistently demonstrated a clean history of repayment. This assessment is known as checking a company’s ‘credit worthiness’. The availability of their assets in combination with the extent of their liabilities is also highly useful in determining the probability of their default. Furthermore, credit references help to form a vital part of a full commercial credit check on a particular business. In addition, a business can also take precautionary measures by making sure there is clarity with regard to the terms of supply credit. Finally, it is advisable to investigate the possibility of obtaining a personal guarantee from a client business director.
Debt collection procedure
To prevent debts getting out of hand from day one, a company must have a robust debt collection procedure in place. This procedure must be continuously monitored. This applies to companies that have experienced the negative aspects of dealing with customers not fulfilling obligations on payment, as well as those that wish to avoid this altogether.
Terms of Agreement
Managing the process of avoiding bad debt starts with following up on debts as soon as they are overdue. Setting out stricter terms such as the supply of goods Code of Practice (C.O.D.), or arranging for prepayments before the work or supply takes place is also a practical measure to avoid later issues. Supply agreements can be put together in writing, enabling a company to have solid proof of agreement to the supply terms. It is also possible to withhold the passing of title in equipment and materials until payment is made. To avoid later claims of unsatisfactory work, it is possible to get a customer to sign an agreement that the work was completed to their satisfaction. It is also worth looking into the possibility of setting up progress payments for ongoing contracts or work.
Late payment penalties
Companies are legally entitled to charge interest on late payments, thus deterring clients or customers from making late payments. The process for this can start 60 days after the client has been provided with the service or an invoice has been issued. In the UK for example, current statutory interest plus the Bank of England base rate (0.5%) is charged for business transactions.
Including interest calculations for late payments
A business should keep their client up to date on changes to outstanding fees. Furthermore, business to business legislation allows for companies to charge a fixed sum for the administrative costs incurred when chasing late fees.
Scheduling a reminder two or three days before payment is an effective way to avoid late payment. In many cases, it is simply that the client has forgotten the deadline. Reminders also help to build a good working relationship with the people in the client’s accounts department, as well as ensuring timely transactions in the future. Keeping records of each client’s payment history allows companies to see a pattern in client transactions. Reminders and any other communications can then be adapted to fit this pattern.