A company’s executives understand that growing sales and generating revenue is important, but they also know the strategic importance of credit risk management. This practice enables the organization to adopt sound policies for estimating and writing off bad debt, as well as monitoring the financial situation of customers and service providers.
Bad debt management enables a company’s leadership to establish a sustainable credit-risk awareness program for all employees, from department heads and segment chiefs to rank-and-file personnel. Bad debt covers money the business might never recover from a customer, either because the client has filed for bankruptcy or is barely making ends meet. Bad debt and credit risk management go hand in hand, because an organization can gradually reduce -- or permanently remedy -- default risk by thoroughly checking customers’ financial situation before granting credit and delivering goods.
Writing off an account receivable means an organization is taking the asset off its balance sheet. Accounts receivable are short-term assets a business expects to convert into cash within 12 months. Consequently, writing off assets causes the company to incur losses. A typical write-off policy covers tools and methodologies an organization follows to identify customers in financial distress, monitor their economic situation over time, send timely reminders and late-payment notifications, enlist the help of collection agencies, and offer rebates on outstanding balances and early-payment incentives to cash-strapped customers. When all these efforts are fruitless, the company may write off the accounts receivable.
Companies that do not write off accounts receivable generally overstate revenues and assets -- a perennial scheme of fraudulent financial reporting that typically invites adverse regulatory decisions. A company that doesn’t charge off its bad receivables is, in essence, telling the public it has generated specific amounts of sales when, in fact, it made less money over the period under review. Regulatory agencies, such as the U.S. Securities and Exchange Commission, may levy hefty fines on the reporting company, especially if public officials see a pattern of consistent “book cooking” instead of accurate bookkeeping.
To record bad debt, a corporate accountant debits the bad debt expense account and credits the “allowance for doubtful items” account. In some cases, a business may write off an account receivable without going through the minutiae of credit risk appraisal and bad debt estimation. This could happen if, for example, a customer declares bankruptcy or engages in an abrupt liquidation scheme the vendor didn’t foresee. In this case, the journal entries would be: debit the bad debt expense account and credit the corresponding customer receivable account.