Why Your Small Business Must Avoid Writing Off Bad Debt
For business owners, there is no worse feeling than acknowledging a receivable will not be collected. But, that bad debt has to get off your books, even if a processed payment won’t be doing the act. Therefore, to erase this unpaid balance, some business owners are left to write off this receivable. Only businesses using the accrual method of accounting (when you claim income as you earn it) can write off bad debt. If you are using the cash method of accounting (claiming income only when you receive payment), then you are not eligible to. However, for those operating on the accrual method, don’t think you have an advantage. In fact, writing off bad debt should always be a last resort. It’s important to understand just what it means to write off debt.
What is a Bad Debt Write-Off?
As you know, your receivables are added to your books until you get paid or stop pursuing payment. They are listed as current assets, under the assumption that they will become cash by the end of the year. What’s tricky about this is when you operate on trade credit (if you provide a good or service and then bill the customer after), you are considered an unsecured creditor. What’s the difference between a secured creditor and an unsecured creditor? An unsecured creditor is not protected if the debtor declares bankruptcy. The only way around this would be if your specific business happens to come under a lien statute in your state. But for those businesses who can’t file a lien, if a receivable cannot be collected, a write-off is the only option.
How to Write Off Bad Debt
When writing off your receivables, be aware that you will not need to list which of these debtors are not going to pay. You simply need to estimate the total amount of debt you do not think you will collect. You must use the direct write-off method when dealing with your receivables. However, you can only write off these receivables when you actually give up on collecting them. So if you plan on writing off a debt and then continuing to call up the customer: don’t. Once it’s off the books, it’s gone.
When to Give Up On Collecting a Debt
The next question to ask is, “When can I determine a receivable is uncollectable?” There are many, many indicators, unique to every situation. If you can’t seem to get a customer to respond to you no matter what, that’s a good sign. However, the best static indicator is the age of the receivable. Some Fortune 500 companies take an extremely long time to pay, so this wouldn’t necessarily apply to them, but statistically speaking, once a commercial debt reaches 90 days old it becomes increasingly harder to collect, leaving anything over 120 days old near impossible to. That timeline is good to reference, but also trust your gut and your past history with the customer.
What It Really Means to Write Off Bad Debt
What most do not realize is the effect that bad debt has on a business’ bottom line. It’s not just losing cash your company has earned. Compensating for write-offs is no easy task. Think about this:
If you had $20,000 in write-offs last year and a profit margin of 4%, you would need $500,000 in additional sales to compensate for your write-offs.
You really lose more than you realize when writing off bad debt.
Preventing Bad Debt
Set yourself a goal: never find yourself “giving up” on debt. Get to a point where you CAN collect it all. It’s about making your receivables a priority, so you never let another due date slide. Persistently pursue those unpaid invoices. It takes time, but not as much time as trying to compensate for a write-off. Also, try a few other options before the “give up” point. For example, a commercial collection agency, a collection lawyer letter or small claims court are all options. Although these are also “last resorts” of a kind, they all make more sense financially.
Did you write off debt last year? If so, see how many additional sales you would need to make to compensate for these with this free write-offs monitor.
