Understanding, managing and accounting for bad debts
Bad debt refers to an unpaid debt or invoice that has a high risk of non-collection. In other words, a debt is considered doubtful when the company to which a sum of money is owed has doubts about the ability of its debtor customer to pay the debt in full.
This uncertainty can weigh heavily on the financial health of your business. So, what to do when payments are slow to materialize? And above all, how to manage and prevent bad debts? Find in this guide everything you need to know about the management and accounting of doubtful debts , and how to operate an effective debt recovery procedure.
Bad debts: definition, origins and consequences
In accounting, a bad debt refers to a sum of money that the customer owes to a company in exchange for a good or service , but of which a significant part is likely to be lost despite any recovery attempt. Not to be confused with a bad debt which is by definition 100% unrecoverable.
Bad debts have a strong impact on cash flow since they delay expected cash receipts and affect disposable income.
The most common origins of bad debts
- Customer Defaults or Financial Difficulties : Customers may face financial difficulties such as job loss, bankruptcy, or other economic problems that prevent them from repaying their debts.
- Poor financial management : some clients, because they mismanage their accounting, do not respect the agreed payment terms.
- Disputes or disagreements over the terms of the contract : if the product or service provided does not meet the customer’s expectations, this may result in late or unpaid payments.
- Economic Changes: Economic fluctuations, such as recessions or inflation, may impact clients’ ability to repay their debts.
- Fraud : In some cases, fraudulent activities can result in bad debts. This may include cases of credit card fraud or identity theft for example.
The consequences of bad debts on your business
Bad debts are typically treated as potential losses in a company’s financial statements, which can affect its profitability and financial health . Here are the details of the negative impacts of bad debts:
- Reduction in cash flow: Bad debts lead to reduced cash flow , as the company fails to collect amounts owed. This may affect the company’s ability to finance its daily operations, invest in new projects and meet its financial obligations.
- Increased administrative costs: The business may have to commit additional resources to recover outstanding debts, resulting in additional costs. This includes legal fees, collection costs and administrative costs associated with debt management.
- Reduction in profitability: Bad debts can reduce the overall profitability of the business because expected revenues are not realized. It can also affect the company’s ability to distribute dividends to shareholders.
- Decline in net worth: If bad debts are significant, they can reduce the company’s net worth, which can have implications for its overall valuation.
- Impact on credit capacity: Bad debts can also affect the company’s ability to obtain credit from financial institutions. Lenders often look at the quality of a company’s receivable portfolio when assessing its creditworthiness and ability to repay debts.
- Impact on investor and business partner confidence: Ineffective receivables management can affect investor and business partner confidence in the financial stability of the company. This may lead to a reluctance to invest further or establish business relationships.
The impact of bad debts on a company is therefore far from negligible.
To minimize the risk of bad debts and to effectively manage situations where they occur, it is therefore important for businesses to have effective collections management policies and procedures in place .
What are the warning signs of bad debt?
There are several warning signs of potential bad debt coming your way. You must know how to identify them before unpaid debt becomes a significant problem for the financial health of your business.
- More frequent delayed or missed payments from a customer : One of the most obvious warning signs of bad debt is when one of your customers consistently delays or misses payments. If you notice a pattern of late payments or excuses for non-payment, this may indicate that your customer is having financial difficulties or is intentionally avoiding payment.
- Communication breakdown: dialogue is essential in any business relationship. If you start to have difficulty communicating with a customer regarding unpaid invoices, this could be a sign of problems. Ignored emails, unanswered phone calls, or constant avoidance when trying to discuss payment terms may indicate that your customer is intentionally avoiding the issue. Don’t delay in taking matters more firmly into your own hands to put things back in order quickly.
- Financial difficulties : Another warning sign to be aware of is a client’s financial situation suddenly deteriorating. To check this, it is important to regularly monitor your customer portfolio or at least those who generate the most turnover (Google alerts, financial information available on the platforms, press releases, etc.).
Quickly identifying the warning signs of bad debts is strategic to preserve your company’s cash flow and reduce customer credit risks.
To do this, we strongly recommend that you regularly monitor the solvency of your customers and their progress and then analyze their payment behavior.
How to limit the negative impact of bad debts?
To minimize the impact of bad debts, here are 5 best practices to adopt:
1) Take preventive measures to avoid the accumulation of bad debts
Offering a trade discount (also called a cash discount) to a customer can be very effective. It involves getting the customer to pay their invoice early, in exchange for a commercial discount. Inexpensive and easy to set up, discounting is an interesting response to cash flow gaps and the risk of unpaid debts.
2) Implement solid credit management
Customer credit policies and procedures must be very clear and well communicated to your internal teams as well as to your customers.
When, for example, you clearly mention in your Terms of Sales or your contracts the payment terms, possible payment methods, interest on delays and the consequences in the event of non-payment, you ensure that your customers are fully aware of their obligations and responsibilities when they place an order with of your company.
3) Closely monitor customer accounts
Keep your customer contact database up to date, to transmit your invoices and send your reminders to the right person. As the job market experiences many changes, it is essential to strengthen the quality of customer contact information to reduce the risk of bad debts.
Also regularly check the good financial health of your customers and closely monitor their solvency indicators . Legal information, financial statements, profitability and solvency indicators are all elements that will allow you to know if a company has the capacity to pay its debts.
4) Invoice quickly and accurately
Invoicing is a rigorous step which constitutes a real opportunity to reduce the risk of doubtful debts.
Quickly send your invoices to your customers as soon as the products or services are delivered. Include all useful information on the conditions and methods of payment. You will thus help your clients in their own accounting management and you will limit cases of doubtful debts including gold
5) Implement effective debt collection procedures
Implementing effective debt collection procedures is essential to ensure the financial stability of your business and drastically reduce the number of bad debts.
Recovery procedures, for them to be profitable, must be carried out in a rhythmic, systematic and continuous manner over time. Here are the key steps:
- Set up a proactive monitoring system for customer accounts, this will allow you to quickly identify potential payment delays.
- Send payment reminders before the due date.
- Establish open communication with customers in the event of late payments. Identify the reasons for the delay and find solutions.
- Offer flexible payment options to help resolve customers’ temporary financial issues.
- Formalize a clear collection policy, describing the steps to follow in the event of non-payment.
Bad debt recovery: outsourcing, an effective approach
If, despite your efforts, late payments persist, consider outsourcing collection to specialized agencies .
Debt collection is a profession in its own right and requires a perfect command of telephone negotiations. In the current tense economic context, we cannot simply demand payment of our invoices, we must negotiate with our customers.
Considering entrusting the recovery of your debts to professionals experienced in handling these issues will also guarantee both legal compliance and the preservation of your commercial relationships.
And, if amicable negotiations are unsuccessful, collection companies will be able to lead legal proceedings to recover your unpaid debts .
Finally, if despite all efforts to recover your debts have failed, a collection company will be authorized to give you a certificate of irrecoverability . This official document will certify the irrecoverable nature of your doubtful debt and allow you to write it off as a definitive loss to recover the corresponding VAT.
Bad debts: how to account for them
Accounting for bad debts is an important step in the financial management of a company. Here’s how to do it:
- Provision for doubtful debts : Once the risk of non-recovery has been assessed, it is recommended to establish a provision for doubtful debts. This provision represents an estimate of the probable loss linked to doubtful debts and is recorded as an expense in the company’s accounts.
- Debit Expense Account : Record the allowance for doubtful accounts by debiting an appropriate expense account, such as “Allocations to allowances for doubtful accounts.”
- Credit allowance account : Credit a specific allowance account, such as “Allowance for Doubtful Debts.”
- Regular update: It is important to regularly update the provision to reflect changes in customer circumstances. If the risk of non-recovery increases, the provision should be adjusted accordingly.
- Recording of permanent loss: When it becomes evident that a debt is irrecoverable, it must be recorded as a permanent loss. This is done by debiting the allowance for doubtful debts and crediting the corresponding receivables account.
- Debit Allowance Account : Record the loss by debiting the Allowance Account for Doubtful Debts.
- Credit Accounts Receivable : Credit the bad debts account to recognize the loss.
- Reduction of the provision in the event of recovery: If a doubtful debt is recovered after its recognition, adjust the provision accordingly.
- Debit Allowance Account: Reduce the allowance by debiting the Allowance Account for Doubtful Debts.
- Credit Cash or Receivables Account: Credit the cash account or receivables account to reflect the collection.
To ensure that all accounting regulations are complied with and that provision estimates are appropriate, we recommend that you consult your accountant.
Proactive management of bad debts helps maintain a healthy financial situation and avoid excessive customer credit risks.
By implementing proactive management of unpaid debts and adapting it to the specific nature of your business, you maximize your chances of recovering unpaid debts efficiently. You also strengthen the trust and connection your customers place in you while ensuring the future of your business.
MANAGEMENT CREDIT EXPERT supports you from A to Z in the management of doubtful debts . For more information, contact us via our contact form.