“But my BAD debt isn’t really that bad… is it?”

Unless you get money from customers up-front before you give them the product or service they purchased from you, you will likely get shafted now and then from customers who will never pay.

In spite of your best efforts, these receivables end up getting older and older and you realize that you will never collect from them. Everyday people might call this “hopeless” but in accounting lingo, it’s called “bad debt“.

It’s tempting to just ignore your bad debt. (Hey, no business owner wants to be reminded of a customer who pulled a fast one on them). Unfortunately, doing that will artificially inflate the assets on your balance sheet while also misstating your profit.

But you do need to do something with these numbers! Here’s what to do:

1.   On the asset side of your balance sheet, reduce your accounts receivable by the amount of the bad debt.

“But something’s not right!” you say. “The two sides of the balance sheet are supposed to be equal! If I reduce my assets by the amount of the bad debt, they won’t be equal anymore!”

Good point! So here’s the other thing you need to do:

2.   In your income statement, add a bad debt expense (just make sure that you add it into the same time period that the sale was made).

Here’s what happens as a result: The profit in your income statement will be reduced by the amount of the bad debt and it will be reflected back into your balance sheet.

Here’s a simple example to illustrate:

Mary’s company has a balance sheet that looks like this:

Assets
Stock: $50
Receivables: $20
Cash: $10
TOTAL: $80

Liabilities
Loan: $20
Payables: $40
Capital: $20
TOTAL: $80

If Mary has a $5 bad debt, here’s what she will do:

• First, she will reduce the receivables in the assets column of her balance sheet by $5.

• Second, she will add an expense of $5 in her income statement, which will reduce her profit by $5.

• Third, she will go back to her balance sheet, this time to the liabilities column of her balance sheet (where profit is part of capital), and she will reduce that by $5.

Bad debt is no fun and there are many things you can do to avoid it. However, if you do get it (and you probably will at some point), this is how you make the adjustment in your financial statements.