What is bad debt and what to do about it?

Basically, it is an irrecoverable receivable – a type of expense that occurs when a customer to whom you have extended credit is no longer able or willing to pay you. In accounting terms, this is known as a “bad debt expense” which must be charged against your company's accounts receivable.

Consequently, because the bad debt expense reduces the value of the accounts receivable on your company’s income statement, bad debt financial projections and cash flow. In addition, the financial harm can spread to other businesses in your ecosystem as well.

In most cases, the reason is simple: your customer simply cannot pay the bill due to insolvency or bankruptcy.

Your customers may be experiencing delays in payment themselves. They may be enduring supply chain problems that are slowing down deliveries of components they need to manufacture the goods they sell.

Your customer’s bank credit line may have been withdrawn, curtailing his or her operating capital. The market may have turned down suddenly, impacting sales and the overall busines model.

It could also be that you’ve extended credit to an unsuitable customer. If this is the case, you should tighten up your credit control policy to prevent it from happening in the future.

Bad debt can also be the result of credit fraud, in which your business has been deliberately targeted by criminals, or a customer misrepresented himself in obtaining a sale on credit from your company and has no intention of ever paying you.

Keep in mind that the first sign your receivables are in danger of becoming a bad debt is late payments of invoices.

It’s important to classify bad debts as such so that investors can see that all your accounts are in good order.

But remember: the manner in which you record bad debt expenses will differ depending on the country you’re based in. For example, most businesses based in the UK use international financial reporting standards (IFRS), while much of the rest of the world uses generally accepted accounting practices (GAAP). 

There are two main ways to record a bad debt in accounting: bad debt write-off and bad debt provision.

Bad debt write-offs are used when you have a specific and recognisable bad debt on your accounts. In other words, you know that the debt is irrecoverable. In the bad debt write-off method, you’ll debit the bad debt expense for the amount of the write-off and credit the accounts receivable asset account for the same amount.

Note that the bad debt write-off is used primarily by UK-based businesses using IFRS. Bad debt write-offs don’t comply with GAAT requirements.

A bad debt provision or allowance is an accounting method that requires you to estimate the amount of bad debt that you expect to write off in any given period.

In brief, you charge an estimated amount of accounts receivable to bad debt expense, before debiting the bad debt expense for the estimated amount of the write-off. Finally, you’ll credit the same amount to the bad debt provision contra account.

This is applicable when you have already accounted for VAT but your customer defaults on full or partial payment. Specific criteria and conditions differ from country to country, but in general tax authorities allow companies to claim back the already paid output tax on bad debts.

If your company receives payment of a part of the debt, an adjustment for the bad debt relief already claimed must be made.

This form of debt relief is applicable when a customer defaults payment (in full or part) to your company for any supply of goods or services at the end of a specific period and you have initially credited or refunded the relevant input tax. Your customer must reverse the input tax related to the defaulted payment as output tax and the relevant tax amount must be paid back to the tax authorities.

If bad debt relief is paid, your company adjusts by reducing the VAT on purchases for the period in which the debt relief payment is received.

This procedure can be instrumental in avoiding expensive legal measures. If your customer misses a payment deadline, chase the outstanding invoice quickly: send a bad debt letter to try to collect the late payment and prevent it from becoming a bad debt.

The bad debt letter should be succinct, written on your company letterhead, include your signature, and suggest how to resolve the matter in a timely fashion. Learn more by reading our article on how to collect late payments, that includes tips to write bad debt letters.

Remember: you don’t want to alienate your customer. Find a balance between firmly insisting on the matter being resolved and the need to maintain a positive customer relationship.

Debt collection requires a great deal of expertise that some companies do not have. Commercial law, for example, is often complex and varies greatly from one country to another. To help you, do not hesitate to check our country risk reports that give you information on how to manage these local risks and practices effectively.

When you add on the time and money you will spend trying to collect a debt, it becomes clear that overdue debts cost more than the face value of the bill.

Forewarned is forearmed.  A significant bulwark is bad debt insurance – also known as non-payment insurance or trade credit insurance: if your customer fails to pay you, your insurer compensates your company and protects your cash flow.

Bad debt insurance from Allianz Trade not only protects businesses, but also provides monitoring and financial information about your customers and prospects, and knowledge of marketplaces. These insights are valuable components of understanding what is bad debt, of helping you make better-informed decisions and of creating a successful business strategy.

Generally, the premium for your bad debt insurance is calculated depending on your sector of activity and your turnover.

For example, the bad debt insurance cost for a company with an annual turnover of €10 million in a low-risk market (such as an European Union country) will be around €1,500 a month for a standard trade credit insurance policy. However, this amount varies depending on the chosen type of coverage and sector.

With local expertise in more than 55 countries around the world, we support your company worldwide with investigators, negotiators and legal teams who help to recover outstanding payments efficiently and in the shortest possible time. It’s an effective safeguard against bad debt and provides confidence to trade.