Bad debts of your business are the money that you are sure you will not collect. You only have to record the bad debts if your business sticks to the accrual accounting principle — that is when you record transactions at the time of making the deal, even if the actual payment has not been done yet.
While you are still unsure whether the payment will be made or not, you register it as accounts receivable in your ledgers and accounting reports. Once you decide the payment is uncollectible, it turns to an expense for your company. All the bad debts you have can be found in the general ledger.
Jack sold coffee packs on credit to a coffee shop owner. The client did not pay for the goods for months and once Jack learns that the client went bankrupt and fled to Puerto Rico. It becomes clear for Jack that the money will not be paid and he decides to brand the debt as a bad debt in his accounting books and to write it off from the ledgers.
How to write off bad debts?
Once you decide that you do not expect the payment to be made, you can write it off from your ledgers and reports. If you are not sure how to do it or just do not want to bother yourself with the task — outsource your bookkeeping and accounting.
You can write off your bad debts in 2 ways: writing them off directly, or using an allowance method. If your business relies much on credit sales, it is better to stick to the allowance method to make your business ready for unexpected non-payments.
With the direct write-off method, you record the bad debt as an expense in the general ledger — equal to the account receivable.
|Bad debt expense||£500|
With the allowance method, you make a reserve in your accounts for covering the bad debts in advance.
Let’s say you make your bad debt allowance £1,000. You make a record in the ledger:
|Bad debt expense||£1,000|
|Allowance for bad debts||£1,000|
You have a customer who owes you £100 and will not certainly pay you. You decide to write the debt off and make the following entries:
|Allowance for bad debts||£100|
To define the sum of your company’s bad debt allowance, you count the percentage of bad debt. Mind that this percentage will only help you to make estimations, not to see the exact figures. Here is the formula:
Percentage of bad debt = Total bad debts / Total credit sales
Let’s say you had £100,000 in credit sales for an accounting period and counted £15,000 to be uncollectible. Applying the formula:
£15,000 / £100,000 x 100 = 15%
In this case, the amount of the allowance for future bad debts should be equal to 15% of the credit sales.
Say, in May you have £110,000 of credit sales. Allowance for bad debts for next month equals £16,500.
Can VAT on bad debts be claimed?
If you have already paid VAT to HMRC on the sale of your goods or services, but with the time you do not get the money for that and write it off as a bad debt expense — you can claim the VAT back if the following conditions are met:
- The debt is no less than 6 months old and no more than 4 years and 6 months old.
- You have not sold the debt on.
- You have not charged more than the normal price for the goods or services sold.