Last editedDec 20222 min read
In this post, we’ll define bad debt and impairment to give you a clear idea of what the terms entail and how they can affect your business.
What is bad debt?
Bad debt occurs when a customer fails to repay the credit a business extended to them. When the customer fails to repay, the amount they owe is deemed uncollectible and is recorded as a charge off. A charge-off is a debt which is marked as highly unlikely to be paid.
Bad debt is an eventuality that must be accounted for by businesses that extend credit to customers, as there is always a risk that the customer won’t pay.
What causes bad debt?
There are a number of reasons why a business may end up with bad debt. Sometimes, it’s simply a case of extending credit to the wrong person. When this occurs, it’s worth looking into improving your credit policy to avoid it happening again. It can also be due to targeted fraud. However, often it’s due to the customer being unable to pay due to insolvency or bankruptcy.
How to record bad debt
There are two main methods for recording bad debt:
the write-off method
the provision method
Bad debt write-offs are employed when you are certain that the debt is irrecoverable. It involves debiting the bad debt expense for the amount of the write-off and crediting the accounts receivable asset account in equal amounts. This method is often used in the US for income tax purposes.
Note, however, that the bad debt write-off method is not adherent with the matching principle outlined in accrual accounting and Generally Accepted Accounting Principles (GAAP). This means that if you use GAAP for accounting, you should opt for the provision method instead.
Bad debt provision is an accounting method that involves estimating the amount of bad debt that will need to be written off within a certain period. The first step is to charge an estimated amount of accounts receivable to bad debt expense. Next, you debit the bad debt expense with the estimated write-off amount. Finally, you credit that same amount to the bad debt provision contra account.
Avoiding bad debt with GoCardless solutions
GoCardless offers an online ACH debit solution that can facilitate the payment collection process on behalf of your business. As payments are pull-based, businesses are in full control of the payment amount and the date that it occurs. This reduces the risk of late payments or failed payments, in turn reducing the risk of bad debt.
What is impairment?
In accounting, impairment refers to a permanent reduction in the value of a company asset, either fixed or intangible.
When assessing an asset for impairment, the profit, cash flow and benefits linked to the asset are compared to its book value. If its book value exceeds future cash flow and benefits associated with it, then the difference is written off and the value of the asset reduces - as noted on the balance sheet.
What causes impairment?
Impairment can be caused by a wide range of factors. For one, it may be due to an unforeseen accident or disaster. For example, the loss of outdoor machinery or equipment due to extreme weather.
It may also be due to changes in legal circumstances surrounding the asset, rendering it of lower value. An example of this might be a piece of machinery that is now by law only allowed to be operated by individuals with a particular qualification.
There will also be a change of factors affecting market demand for the asset. This might involve the asset receiving a bad reputation for being non-environmentally friendly, for instance.
We can help
GoCardless is a global payments solution that helps you automate payment collection, cutting down on the amount of financial admin your team needs to deal with. Find out how GoCardless can help you with one-off or recurring payments.