How to Write Off Bad Debts: Guide for Business Owners

Handing bad debts, or unpaid debt, is a common challenge in many businesses across Canada. The big question on everyone’s mind – how can your business write off these bad debts?

When customers don’t pay their bills, it can hurt your company’s cash flow and financial stability. It’s important to know how to properly write off these debts to keep your financial records accurate and your business sustainable.

Here’s a straightforward guide to help you manage this process. Let’s get into it.

Key Points

What is Bad Debt?
What are the types of bad debt?
How Does a Company Write Off Bad Debt?
Step-by-step guide to writing off bad debts
Why it’s important

What is bad debt?

Bad debts occur when you’ve provided goods or services on credit, and the customer fails to pay. This not only impacts your cash flow but also inflates your receivables, giving a misleading picture of your financial health. On your financial statements, specifically the income statement and balance sheet, bad debts need to be accurately accounted for to reflect your actual financial position.

What are the types of bad debt?

There are a few different types of bad debt, each coming with its own set of circumstances. Let’s break it down, so you can understand what might be happening with your business finances.

1. Commercial bad debt

Imagine you have a business, and you sell products or services on credit to another business. If that business runs into financial trouble, disagrees with the value of what they bought, or simply doesn’t pay up, you’re left with commercial bad debt. It’s a tricky situation, as it depends heavily on the financial health and integrity of the other business.

2. Consumer bad debt

Consumer bad debt is something many of us might be more familiar with. It happens when individuals buy goods or services but fail to make the payment. This could be due to a tight financial situation, dissatisfaction with the purchase, or even just forgetting about the bill.

3. Secured vs. unsecured bad debt

Bad debts are also categorized based on whether they are secured or unsecured:

Secured Bad Debt involves loans or credits that are backed by an asset, like a house or a car. If the payment isn’t made, the lender can claim the asset to recover the losses. It’s a way for businesses to have a safety net.
Unsecured Bad Debt doesn’t have this kind of protection. There’s no asset to fall back on, which makes it a riskier scenario for the lender.

4. Aging bad debt

Then, there’s the age of the debt to consider. The longer a debt goes unpaid, the harder it becomes to collect. Businesses often keep a close eye on this, deciding whether to make more effort to recover the money or write it off as a loss if it seems unlikely they’ll be paid back.

How Does a Company Write Off Bad Debt?

To manage bad debts, you have two primary accounting methods at your disposal:

Direct Write-Off Method

This method involves directly removing the uncollectible amount from your accounts receivable when it becomes evident that the debt won’t be paid. It’s straightforward but may not always align with accrual accounting principles, as it fails to match revenue and expenses in the same accounting period.

Allowance Method

More aligned with accrual accounting, this method involves estimating the amount of bad debt that will occur in an accounting period and creating a provision for these expected losses. It helps in matching the expense of bad debts to the period in which the related revenue was earned, providing a more accurate picture of your business’s financial health.

What’s The Process For Writing Off Bad Debt?

Review your receivables to spot potential bad debts early.
Decide whether the Direct Write-Off Method or the Allowance Method is more suitable for your business based on the volume of your credit sales and the regularity of uncollectible debts.
Using the Direct Write-Off Method, you should debit the bad debt expense and credit accounts receivable to clear the specific amount that can’t be collected. With the Allowance Method, debit the bad debt expense and credit an allowance for doubtful accounts, which covers estimated uncollectible amounts.
Reflect bad debt write-offs in your financial statements. This adjustment will decrease your net income on the income statement and adjust the receivable balance on the balance sheet.

Why Is It Important To Write Off Bad Debts?

Writing off bad debts correctly is important because it keeps your financial statements true to your business’s financial condition, helps in tax preparation by identifying deductible expenses properly, and supports your cash flow management by offering a clear picture of available funds.

Take back financial control with Harris & Partners

Business debt can feel overwhelming, but you don’t have to face it alone. Our team of expert Licenced Insolvency Trustees is here to help you find your way back to financial security:

We specialize in crafting tailored strategies to lessen your debt load, taking into account the unique details of your business. Our approach is all about personalization, ensuring we find the best route to not only clear your current debts but also to lay the groundwork for your business’s future success.

We’ll work closely with you, providing transparent guidance every step of the way. From restructuring plans to negotiating with creditors, we’re focused on securing your financial freedom with the right debt relief solution. Don’t let the stress of corporate debt hold you back – give us a call today.