What to do When Business Debt Becomes Uncollectible
Whether you’re a business owner, business credit manager, or collections manager, you know that you won’t always be able to collect on every outstanding invoice. Ultimately, once you’ve exhausted all reasonable collection efforts, you may have to write it off as bad debt. Deeming the invoice uncollectable and writing it off as bad debt should be a last resort, as the losses can add up quickly have a negative impact your company’s bottom line.
So how do you protect your business from losing too much on bad debt write-offs? First, you must ensure that you establish a bad debt reserve, also known as an allowance for doubtful accounts, to offset any losses you expect to incur within the year. However, it’s a challenge to forecast precisely how much bad debt your business will accumulate over a certain period of time.
One way to avoid this is by performing better customer risk assessments for potential customers and monitoring existing customers’ financial health.
What is a Write-Off?
Before discussing the potential impact that bad debt can have on your business, it’s important to understand what a write-off is. According to the Internal Revenue Service, if a customer fails to pay off a loan or a line of credit that was recorded and reported as income, you can write off their debt as uncollectible (or bad debt).
Writing off bad debt simply means that you can deduct it as a loss on your tax returns and reduce the amount of money you owe to the IRS. However, if you don’t calculate your write-offs properly, any taxable revenue benefits you receive won’t be enough to offset the loss.
Writing Off Bad Debt
Generally, there are two different ways that companies can write off bad debt. You can either perform what’s called a direct write-off, or you can implement a bad debt reserve to write off uncollectible money.
A direct write-off occurs after a debt is deemed uncollectible. In other words, the full amount of bad debt isn’t determined until after the end of the sales period. This can lead to inaccurate balance sheets, and auditors may choose not to certify your financial statements as a result. Direct write-offs cannot be used if your company adheres to GAAP accounting standards.
Bad Debt Reserve
Establishing a bad debt reserve, or an allowance for doubtful accounts, is the preferred method for calculating and writing off bad debt. As the name implies, this method involves setting aside a certain amount (a reserve) to account for anticipated uncollectible debt. There are a variety of variables to consider when calculating how much bad debt reserve you should budget for.
Of course, you’ll want to look at the previous year’s bad debt percentage (bad debt divided by total sales) as a baseline. But you’ll also want to adjust for other factors, such as any changes in the economy, as well as any financial data you might have on your customers.
For example, if your bad debt equaled 1% of all sales last year, but the economy has significantly improved since then, you may decide to budget a reserve of just .5% of budgeted sales for the year.
Of course, companies that perform comprehensive risk assessments to screen customers ahead of time and monitor their financial health will be able to calculate non-payment risk and bad debt expenses much more accurately.
However, forecasting bad debt based solely on historical aging receivables is no longer permissible for companies required to comply with CECL (which stands for current expected credit losses), a new accounting standard. CECL mandates that forward-looking, or predictive data, be used to establish a bad debt reserve. Dun & Bradstreet’s Portfolio Risk Manager for DNBi reporting software provides an automated, consistent, and repeatable process for calculating a bad debt reserve.
Minimizing Bad Debt
While it’s important to always have an accurate bad debt reserve, especially for companies that extend business credit, the ultimate goal should always be to minimize the amount of bad debt you incur.
As mentioned earlier, more companies these days are relying on predictive risk data to help them make better informed decisions about potential customers, so they can minimize the amount of bad debt they incur.
Companies like Dun & Bradstreet can provide valuable data to help identify whether a particular business is high risk, and possibly not worth doing business with. For example, the D&B® Failure Score indicates if a company is likely to experience financial distress in the next year; and the D&B PAYDEX® Score can identify if your prospective customers have a history of paying late (or not at all).
As you can see, although write-offs can help offset some of your total yearly losses, they don’t cancel them out completely. No matter which way you slice it, bad debt costs money. And when it impacts your company’s profitability, the damage can have lasting effects. Adding a bad debt reserve to your budget will help cover predicted losses, but having preventative measures, like risk assessment tools in your toolbox, will give you even greater peace of mind.