Bad debt occurs when a customer is unable or unwilling to pay. Let’s take a look at how to account for it.
Many businesses who sell to other businesses offer credit terms. This means selling and dispatching goods under an agreement that the customer will pay within a certain number of days, normally 30.
The sale is recorded in the accounts, which increases turnover. It’s important to make provision for doubtful debt when offering credit terms to customers, so that you don’t overestimate turnover.
You then wait to receive payment from the customer, and will usually call and send a letter and statement of account to chase the payment if it’s not received promptly.
If contact with the customer doesn’t work, more drastic steps like legal action might be needed.
There are times, however, when despite chasing, the customer is unable or unwilling to pay. This could be because they have gone into liquidation, which means they won’t be able to pay any of their invoices.
There may even be cases where a customer argues that the goods or services are not satisfactory, and is therefore unwilling to pay.
Writing off debt
If you are sure a customer is not going to pay, you need to write off the debt. As the sale has already been recorded, and turnover has increased in line with this, the turnover must be removed. You also need to take the debt off the customer ledger to reflect that the customer no longer needs to be chased for payment.
Rather than reducing sales, you should record an expense. The reason for this is that the sale did take place, and the good or services were provided; you just didn’t receive the money.
You should create an account called ‘bad debts’, which will be recorded in the expense section of the profit and loss report. This account will be debited to reflect the increased expense account.
The sales ledger control (also known as ‘debtors’ or ‘trade receivables’) should be credited. This is because you are reducing the amount that is owed by the customer, and therefore reducing the asset.
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If VAT was charged when the sale was made, then this must also be removed. You then need to debit the VAT account to reduce the liability.
The double entry used when removing a bad debt is:
- Debit bad debt account with net figure
- Debit VAT account with VAT figure
- Credit Sales ledger control with Gross figure
Accounting for bad debt is covered in more detail on our accounting courses.