As the owner of a small business, you are usually involved in all aspects of the business from human resources to accounting. For this reason, it's helpful for you to familiarize yourself with some common taxation and accounting terms.
If your business is like most other businesses, you know that you will not be able to collect from a certain number of your accounts. Setting up an allowance for bad debts, will allow your company's books and records to be more accurate. This article provides explanations of common accounting terms that relate to bad debts.
Accounts Receivable: Money that is due from your customers. Your accounts receivable balance equals the dollar amount of sales that you have made to your customers on credit terms but that have not yet been paid. The accounts receivable balance is classified as an asset of your company.
Accrual Basis Accounting: An accounting method in which expenses are deducted in the year they are incurred and income is reported in the year that it's earned. Since income is recorded when the sale is made to your customer (instead of when the money is actually collected), it's important to keep track of your company's bad debts.
Allowance for Bad Debts: An estimation of the accounts that you will not be able to collect, meaning that they are bad debts. An allowance for bad debts account is kind of like a savings account for bad debts. Your company puts money into it on a periodic basis (usually monthly) as an expense of the company. When you decide that a particular account is not collectable, you tap the allowance for bad debts account to pay for the bad debt. Because you already made the allowance, your profit and loss statement will not be out of whack in the month that you decide to write off a particular account.
Your company's accounting entries to write off a $500 account that you have decided is not collectable would look something like this: a debit to your allowance for bad debts account in the amount of $500 and a credit to your accounts receivable account for $500.
Bad Debt: An account that your business is unable to collect.
Bad Debt Expense: An expense account that reflects the amount of your company's accounts that are not collectable/bad debts. A typical company makes an estimate as to how much it has in bad debts on a periodic basis, usually monthly. For example, if your company estimates it has about $1,200 per year in accounts that are not collectable, you would make the following accounting entries each month: a debit to your bad debt expense account in the amount of $100 and a credit to your allowance for bad debts account in the amount of $100.
When you actually decide that a particular debt is not collectable, you would not make an entry to the bad debt expense account. Instead, you would debit your company's allowance for bad debts account for the amount of the bad debt and credit your accounts receivable account for that amount.
Bad Debt Recovery: This occurs when a customer pays an account that you had previously wrote off as not collectable. In the event of a bad debt recovery, you need to adjust your company's accounts. If you received a $500 payment, the adjusted entries would look similar to this: a debit to accounts receivable in the amount of $500 and a credit to allowance for bad debts in the amount of $500, and a debit to cash in the amount of $500 and a credit to accounts receivable in the amount of $500.
Cash Basis Accounting: This type of accounting method involves reporting income the year it is received and expenses deducted the year in which they're paid. If your company uses cash basis accounting, you don't need to worry about accounting for bad debts because you record income only when you receive a payment from your customer.
Write Off: This is the act of eliminating a worthless asset or bad debt from the company books/accounts.
Getting Legal Help
If you have questions about the bad debt accounting terms above, or have general questions about starting and running a business, you may want to contact a business and commercial attorney in your area.
For more information and resources related to this topic, please visit FindLaw's section on Business Debt and Bankruptcy.