Credit sales, unlike cash sales, are accompanied with the burden of not only the risk of incurring bad debt expenses, but also the collection of debt and maintaining debtors’ records. “Bad debt” arise when some of your account receivables are unable to be collected. It is important to identify the bad debts and to either initiate the appropriate collection efforts to recover the payment of your outstanding invoices or to write off the debts.
Whether you are a small business, a limited liability company, or a large corporation, invoicing is likely a part of your day to day business practices. Regardless of what type of business entity is at play, getting paid for services, using effective billing processes, managing client payments and overdue accounts while maximizing revenue is a top priority for any successful business. It is important to identify a bad debt when a receivable is determined to be not collectable.
Here are some examples of when an account receivable is considered a bad debt:
- Default in the credit period for payment can often yield a bad debt;
- Customer files for bankruptcy prior to paying receivable;
- Death of liable debtor;
- Client disputes over invoice;
- Business entity dissolves and no individual liability (LLC, corporations, note there are exceptions to no personal liability).
Each credit sale completed by a business has a time frame in which the invoice must be paid. For example, your business might require payment within 30 days, 60 days, 90 days or 120 days. This time frame depends on the credit policies and the contract that governs your businesses relationship with its customers. Often time, defaults in the credit people will result in bad debts. Let’s say your business requires payments within 45 days after the sale, but remains unpaid after 90 days, it is considered a bad debt. It is important to make sure to using an account receivable aging report to track your customer’s remittance and to immediately identify the bad debts in order to prevent incurring more.
In the event your customer has a credit sale invoice outstanding, but files bankruptcy, the debt is immediately considered a “bad debt”. This is because when a person or company files for bankruptcy, they are attesting that they do not have the cash flow to cover their outstanding liabilities, and this inability to pay and lack of cash flow is significant. Bankruptcy is a legal mechanism whereby the person/business acknowledges that they are unable to repay their outstanding invoices due to cash flow restraints. Keep in mind, the person who filed bankruptcy (known as the debtor) is not off the hook unless they are discharged in their bankruptcy proceeding, and may even be required to pay some back pursuant to a court ordered plan for repayment that is slower than the time frame your business imposes. In addition, the bankruptcy court may allow you to recover during a liquidation or reorganization, depending on the type of bankruptcy filed by the debtor.
Certain debts owed by individuals or sole proprietorship will go bad with the demise of the individual. Because individuals and sole owners of businesses are usually personally liable for their debts, their demise will sometimes result in a bad debt situation. For example, if a deceased person’s estate does not have enough to cover the debt at issue, it will likely remain unpaid. A business may have had the deceased person sign the sales contract with a co-signor and/or the spouse, or another liable for the debts of another, may allow for pursuit of payment from them. However, your business may have to relegate the receivables from individually liable entities to bad debts when these unfortunate events occur.
If a customer or client disputes the debt due to the quality or quantity of goods delivered, the dispute will often result in a delay (or even worse, complete non-payment) of outstanding invoices. You have the option of taking the nonpaying party to court, but the delay will likely be longer until the litigation is resolved. If you cannot sort out the dispute with the debtor, the debt should be designated as a bad debt.
A common instance in which a bad debt situation arises is when the customer is a business entity that does not allow for individual liability, such as a limited liability company (commonly referred to as a “LLC”). Often, if an LLC dissolves and has no assets, the unpaid debts of the LLC will not be paid as the individuals will likely not be required to pay them, outside of the operating agreement allowing for personal liability or an argument that the individual did not act on behalf of the LLC in the purchase. If the debt is relatively small, it often makes sense for businesses to consider these debts a bad debt, and initiate actions to write off the debt.
It is imperative that as a business you are diligent in tracking accounts receivables consistently and update your records whenever a debtor remits an outstanding payment. This business practice will not only keep you organized, but will also assist you in identifying bad debts and initiating appropriate actions to either recover the debts or to write the debts off. If you have a long list of outstanding accounts receivables, it is often a relatively inexpensive and worthwhile practice to hire a lawyer to send a collection notice on behalf of your business to attempt to resolve the outstanding debt prior to initiating litigation. In my experience, I have seen numerous matters resolved by a single letter from an attorney demanding payment or litigation will be impending, due to the fact that the debtor wishes to avoid being sued and/or the extra expense of having to defend litigation when they will likely be on the hook for the debt anyways. Remember, if you have a debtor who files bankruptcy and you receive any notice of it, do not pursue any collection activities (or you will violate federal law under the automatic stay imposed by bankruptcy) and move that debt to the bad debt section. Please contact us if you would like assistance in attempting to recover on any of your bad debts as we are experts in collecting money on behalf of our clients in the most effective and efficient way we can.