Doubtful debt is an important part of business accounting and helps safeguard companies from financial instability. Here, we explain what doubtful debt is, how you can estimate it and tips to prevent suffering from late payments.
Doubtful debt refers to the money a business is owed by its customers, that it doesn’t expect to receive.
Doubtful debt can be caused by a number of circumstances. It can arise if the customer raises a dispute about the supply, delivery or standard of goods or services. It can also occur if a customer is experiencing financial troubles, insolvency or has filed for bankruptcy. In which case, the customer may not be able to meet their financial obligations – making it doubtful that their debts will be repaid.
As the name suggest, doubtful debt refers to debt that is unlikely to be repaid. Bad debt, however, is debt that will definitely not be repaid and so needs to be written off. Debt may start off as doubtful, and then transition to bad debt in the future, if it becomes clear that payment cannot be collected. Doubtful debt and bad debt need to be accounted for differently by a company’s finance department.
It’s important to be aware of – and account for – doubtful debt so that you can protect your company’s financial health. Most businesses provide goods or services on credit, which creates ‘credit risk’ – the risk that some customers may not pay either some or all of what they owe. Rather than suffer a financial shortfall that could cripple your cash flow and even lead to insolvency, it’s important to account for doubtful debt. This way, you can prepare for and mitigate its impact, if it develops into bad debt.
You account for doubtful debt by creating an ‘allowance for doubtful accounts’, which is recorded on your company’s balance sheet. This contra account reduces the accounts receivables (the overall payments due from your customers) to reflect only the accounts receivables that you are confident your company will collect. This allowance should be accounted for in the same accounting period in which the sale was enacted.
There are two ways you can estimate the doubtful portion of your accounts receivables. One method estimates doubtful debt using a percentage of total sales, and the other involves individual risk analysis.
The first technique involves looking at your historical unpaid sales accounts over the past five years and then calculating the total value of unpaid accounts for each year. Once this is done, you can determine the average percentage of total sales this figure represents, through dividing the value of unpaid accounts by your total sales figures. So for example, if you had sales of £1million, but lost £20,000 of sales to bad debt, you can establish the allowance for doubtful debt as 2% of total sales for that accounting period.
The second option for estimating doubtful debt is popular for companies that deal with a relatively small number of clients, evaluating them individually to assess the risk they pose. To do this, clients are organised into categories, labelled as high, medium or low risk. Each category is assigned a doubtful debt percentage in accordance with the associated level of risk. These percentages are then multiplied by the total sales of each category to derive an estimated allowance for doubtful debt.
However, the latter method can be problematic because it’s harder to accurately assign new customers into a risk category. Similarly, a client’s financial health can change rapidly, upsetting the likelihood of doubtful debt you have assumed.
Late payment typically leads to doubtful debt, so the best way to prevent doubtful debt is to avoid doing business with customers that pay late. There are a number of proactive measures you can implement to try and mitigate late payment. For example, ensuring all your customers sign contracts with clearly stated payment terms that incentivise early payment and penalise late payment.
Conducting a credit risk assessment of your prospects and regular credit assessments of your current clients can ensure you’re working with reliable customers. It also helps you to assign the right amount of credit. It’s also important to develop strong relationships with your customers so that you can chase payment more easily and effectively. Here, your sales team may be instrumental in achieving a good relationship.
Finally, have effective processes and policies in place to manage late payment. Enabling online payments, and sending invoices and reminders promptly makes it easier for your customers to pay you on time. And if you do encounter late payers, make sure you have established strategic procedures so you can minimise the time and resources spent chasing late payment.