Companies can go through all kinds of financial challenges, and one of these challenges is a bad debt. But what exactly is a bad debt in accounting? How does it affect the financial health of a business? And how can accountants make up for these potential losses? Well, if you wanna find out the answers, you’re gonna have to read on! Now, let’s jump right into it and learn all about bad debts and more, shall we? But first, make sure you know the basic accounting steps that include all the financial statements we will ever discuss!
What Is a Bad Debt in Accounting?
In short, a bad debt in accounting is an amount of money that a business, or creditor, writes off as uncollectible. Now, bad debts can appear for several reasons. First, the customer could go bankrupt or face financial trouble rendering them unable to pay. Second, some customers could refuse to pay due to flaws in the goods that lead to dispute. Third, there is always the option that the second party conducts fraudulent operations, so it doesn’t pay. Finally, poor credit decisions, like loaning to high-risk clients, could lead to bad debts in accounting.
How Do Bad Debts Affect Financial Statements?
Let’s talk financial statements wise. First, we have the income statement, bad debts there reduce the company’s income, and are recorded as expenses. Meanwhile, they reduce accounts receivable amounts on the balance sheet, aka the realistic amount of money the business expects to receive. However, bad debts have no direct effect on the cash flow statement.
How to Handle Bad Debts in Accounting (Or Prevent Them)
There are two ways that accountants can handle bad debts in accounting. The first way is the direct write-off method where they record the bad debt as an expense. Meanwhile, the second is the allowance method, and this is the generally more preferred method. Here, accountants estimate the bad debts and record allowance for doubtful accounts. This allowance will match the accounts receivable, hence evening out the expenses and revenues.
If you wanna try to prevent getting bad debts in accounting, here are some measures you can take. For example, setting clear and strict payment terms for clients is crucial. Add to that things like discounts on early payments, or penalties for late ones. This would be incentive enough for clients to pay on time!
Want Someone Else to Handle the Bad Debts?
Well, you don’t really need to go through all this hassle all by yourself. You see, you can always outsource this side of business to external firms. Luckily for you, Noraal is here to provide that service and many more for your company! So, if you’re ready to take your financial game and growth to the next level, we got your back. All you have to do is contact us today, and we’ll handle the rest!