What Happens When You Write Off Bad Debt?

Writing off bad debt can be an unfortunate but necessary part of running a business that provides goods or services on credit Here’s a closer look at what it means to write off bad debt and the impacts it can have.

What is Bad Debt?

Bad debt refers to money that is owed to a business by a customer, client, or other external party but is deemed unlikely to be paid There are two main types of bad debt

• Business bad debt – This refers to debt that was incurred as part of normal business operations, such as credit sales to customers or loans to suppliers. Business bad debt is deductible on business tax returns.

• Nonbusiness bad debt – This refers to personal loans or other informal debts that went unpaid. Nonbusiness bad debt is treated as a short-term capital loss on personal tax returns.

Debts are considered “bad” when there is evidence that they will not be repaid. This usually occurs when multiple attempts to collect on the debt have failed or the debtor has declared bankruptcy.

When to Write Off Bad Debt

Businesses don’t have to wait until a debt is past due to write it off. A debt can be written off as soon as it is determined to be worthless. This requires looking at all facts and circumstances to determine if there is reasonable expectation of being repaid.

Some signs that a debt is worthless include:

• The debtor has declared bankruptcy
• The debtor has passed away
• The statute of limitations for collection has expired
• The debtor cannot be located
• The debtor lacks sufficient assets to repay

The creditor should document their efforts to collect on the debt to demonstrate it is uncollectible. This includes phone calls, demand letters, using collection agencies, and legal action if cost-effective.

How to Record Bad Debt Write-Offs

Recording bad debt write-offs properly is important for accurate financial reporting. Here are the main steps:

• Business bad debt: Record as an expense against the income account originally used to record the sale. This properly matches bad debt expense to lost revenue.

• Nonbusiness bad debt: Record as a short-term capital loss. The amount of the bad debt can be claimed as a deduction subject to capital loss limitations.

• Use allowance method: Set up an allowance for doubtful accounts to anticipate bad debt rather than writing off specific debts. This normalizes the impact on the income statement.

• Write-off: When specific bad debts are identified, write them off against the allowance rather than expensing again. Update reports and records to reflect reduced accounts receivable.

Tax Treatment of Bad Debt

Bad debt write-offs may be tax deductible depending on the situation:

• Business bad debt can be deducted as ordinary business expense.

• Nonbusiness bad debt can be claimed as short-term capital loss deduction. This is limited to $3,000 per year against ordinary income, with carryovers allowed.

• If debts are excluded from income earlier, bad debt deduction not allowed.

• Must document that reasonable collection efforts were made.

• IRS may require proof that loan was originally made and is now worthless.

Impacts of Writing Off Bad Debt

Writing off bad debt can have the following impacts on a business:

• Reduced accounts receivable – Writing off uncollectible accounts lowers the total outstanding accounts receivable reported on the balance sheet.

• Lower net income – Bad debt expense lowers the net income for the period when the write-off occurs. However, the allowance method normalizes the impact across periods.

• Loss carryovers – Nonbusiness bad debts generate capital losses that can offset future capital gains if not fully used in the current tax year.

• Reduced working capital – Since bad debt represents cash that is no longer accessible, write-offs reduce the working capital available to the business.

• Tighter credit policies – After significant write-offs, businesses may tighten credit and collection policies to reduce future bad debt.

Strategies to Minimize Bad Debt

Businesses can take proactive steps to minimize bad debt losses:

• Perform credit checks and get guarantees from unknown customers

• Offer incentives for early payment of invoices

• Send invoices promptly and follow up on past due accounts

• Consider accepting credit cards or other electronic payments

• Establish clear credit policies and limits

• Use prepayment or COD for higher risk customers

• Work out payment plans if customers are having temporary difficulties

• Monitor accounts receivable aging to catch problems early

While some bad debt is often inevitable, prudent credit management and collection efforts can help minimize exposure. Writing off bad debt properly is key to accurately reflecting financial performance. With diligence and preventative measures, businesses can contain bad debt write-offs and maintain healthy cash flow.