If your business carries accounts receivable, it is reasonable that you may have to write off some bad debt every year.
Lending institutions like to see financial statements formatted using an accrual basis generally following Generally Accepted Accounting Principals (GAAP). If you are a cash basis bookkeeper, you still have an accounts receivable aging (A/R) and you can express your financials in a “modified cash basis” format.
To do that you have to show both your A/R aging and your A/P aging on your balance sheet. If you do show the A/R aging as an asset, you should consider setting up a contra account for allowance for bad debt.
Lenders especially like to know prospective borrowers are realistic and experienced about running their business and when they see an entry on the balance sheet called, “allowance for bad debt” it makes them feel more confident you know how to manage your business.
A contra account offsets another account. If you have a contra account called allowance for bad debt of $3,500, it would look like this on your balance sheet:
Cash in Bank
Allowance for Bad Debt
The red highlights are simply for this post, they would not be in red on your balance sheet.
Obviously if you have no history of bad debt and don’t have any accounts that you reasonably believe could become bad debt, you shouldn’t put this contra account into your balance sheet. Most businesses do have accounts receivable that are old and could legitimately be called potential bad debt.
A good rule of thumb is to include any amounts that are over 120 days past due your anticipated date of payment on your A/R aging. Also include any amounts of A/R when a customer has shut their doors or filed bankruptcy regardless of the aging. You may recover bad debt, but since the value of this debt is doubtful, it is prudent to show it on your balance sheet.
This may sound like a minor point to some people, but the issue is really about the credibility of your financial statements. Using the example above, if one customer represents $27,000 of your A/R (10% of the total) and is over a year old, your banker will question your understanding of your own balance sheet and wonder if you really use your financial statements to operate your business.
Don’t let simple issues like this railroad your chances of getting a loan.
Sam Thacker is a partner in Austin Texas based Business Finance Solutions.
You may contact Sam directly at: firstname.lastname@example.org
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