Dealing with bad debt: How to write off an invoice

What do you do when you realize an invoice you've issued just isn't going to get paid? Perhaps your customer has gone bankrupt, or there's some other reason you can't collect.

That sucks, and we feel for you. The least we can do is show you how to handle writing off the invoice in Wave.

Accounting for bad debt with the direct write-off method

The direct write-off method of accounting for bad debt recognizes bad debt as specific invoices become uncollectible. Accounting purists may point out that this method has a few shortcomings, but it has two big advantages: it's simple to understand, and simple to do in Wave!

Let's start by setting out our bad debt scenario, then see how we will handle the write-off.

Brown Thumb Gardening has gone broke owing you $1,000 for design work.

The clue was in the name perhaps. When you designed the Brown Thumb website, it seemed hard to find enticing images to suit their brand. Now they have gone out of business, and you know you're not going to get paid. Their invoice, number 123, keeps showing up on your Dashboard as overdue, and it's sticking out like - well - a sore thumb.

It's time to bite the bullet and write off this bad debt.

Write off invoice to Bad Debt Expense

Right now, your bookkeeping includes $1,000 of income from Brown Thumb. You've not actually been paid the money, so that is balanced by a $1,000 asset in Accounts Receivable - i.e. money you are owed.

What we want to achieve is that the $1,000 Accounts Receivable asset 'disappears', and that we recognize the loss against your business income. One more thing - we want you to stop having to see that Brown Thumb overdue invoice every time you log in to Wave!

Whenever you issue an invoice in Wave, it adds to your income, and creates a balance in Accounts Receivable until it is paid. The only way to "get rid" of the unpaid invoice, and the Accounts Receivable balance, is to mark it as paid.

But you haven't been paid!

In this scenario, the simplest thing to do is to make use of an imaginary bank account that accountants traditionally refer to as an "Undeposited Funds" Account. An "Undeposited Funds" account is simply an account in Wave that functions like a bank account, but doesn't represent a real bank account that you have in the real world.

You create an "Undeposited Funds" account exactly the same way you create any other Bank Account in Wave — here's a reminder, if you haven't done that in a while. (You can create your Undeposited Funds account as any type of Bank or Cash account, but "Other Bank" probably makes the most sense.)

If you haven't previously created an Undeposited Funds Account, go ahead and create one now. Click Accounting on the left menu, then Chart of Accounts, and then the Add an Account button. 

Writing off the invoice now involves just two steps:

  1. Find the invoice — in this case Invoice #123 for $1,000 — and add a payment for the full invoice amount, paid into your Undeposited Funds account. That's the overdue invoice and the Accounts Receivable balance taken care of!
  2. Go to Transactions and add an Expense for $1000 paid from your Undeposited Funds Account. Categorize the Expense as "Bad Debt Expense."(If you don't already have a Bad Debt Expense category, you can add a new category while posting the expense item.)
  1. Find the invoice — in this case Invoice #123 for $1,000 — and add a payment for the full invoice amount, paid into your Undeposited Funds account. That's the overdue invoice and the Accounts Receivable balance taken care of!
  2. If you don't already have a Bad Debt Account, head to Chart of Accounts and click on Expenses, then on Add a New Account. Add an account called Bad Debt as an Operating Expense Account type.
  3. Go to Transactions and click on Add Expense. Here we will want to add the description (bad debt on Invoice #), Account (Undeposited Funds), total amount ($1000) and mark this as a Withdrawal. Categorize the Expense as Bad Debt.

You now have $1,000 of Bad Debt Expense that offsets the $1,000 income from Brown Thumb, your Accounts Receivable no longer shows an outstanding balance, and your Undeposited Funds account has a zero balance.

What date to apply to your direct write-off transactions

An important principle in accounting is the concept of matching – ensuring that the revenues earned in operating your business for any time period tie up with the expenses incurred to generate those revenues. In general, it's a good idea to date your write-off transactions (the payment and bad debt expense) the same as your invoice. However, you don't want to break prior reporting, so bear in mind these conditions when you would need to apply a later date for your write-off transactions:

  1. Your business charges and recovers sales tax, and you have already reported and/or paid sales tax for the period in which the original invoice was issued. In this case it's usually better to date your write-off transactions some time in the latest period for which you have not yet reported sales tax.
  2. The invoice was issued in your last Financial Year, and you have already completed your year-end statements and filed tax returns. You should date the write-off transactions in the current Financial Year to avoid changing your financial statements for the year that has closed. (If the amount is large relative to your overall revenues, be sure to talk to your accountant who may, under some circumstances, recommend re-filing the prior year.)

Some Common Questions

What about sales taxes?

If you charge and recover sales taxes, writing off bad debt becomes a little more complex. Different jurisdictions have different rules about the conditions and timing under which you can deduct the sales tax element of your bad debts from your sales tax returns. Wave cannot advise on your local rules, and it is important you get advice from your accountant or tax authority directly.

If you operate in a region where the sales tax element of bad debt can be deducted directly from your Sales Tax liability, however, then simply modify Step 2 above by applying Sales Tax to the Bad Debt Expense, just as you would when marking any expense to contain recoverable sales tax. This will offset the Sales Tax recognized on the 'paid' invoice.

Wouldn't it be simpler just to delete the invoice?

It would certainly be simpler, and provided you don't have complex Sales Tax rules to follow, you might choose to do that. But there are three important reasons why it is better to keep the invoice, and 'Pay' it while offsetting the same amount as an expense. These are mostly to do with helping you better understand your business:

  1. Your sales really did include the $1,000 to Brown Thumb. The loss of that $1,000 was a consequence of your client going out of business, not a failure to sell to them or do the work. Calculating your sales income with the $1,000 Brown Thumb income is just a more accurate understanding of what happened in your business.
  2. By recording your Sales income and your Bad Debt expense, you can start to get a sense of the cost of doing business on credit. If you divide your Bad Debt Expense in each period by the Sales Income for the same period, you may start to see patterns, and be able to work out how much bad debt to expect as your business grows. (A change in Bad Debt experience could tell you important things about the quality of clients you are serving, or how effective your collections are!)
  3. If your former customer files for bankruptcy, you may have an opportunity to receive a share of the proceeds of the bankrupcy - even if it is only a small percentage of what you are owed. If there is this chance, you will need your invoice to support your claim.

Accounting for bad debt with the Allowance Method

The Allowance Method of accounting for bad debt is a more sophisticated approach, that does a better job of matching bad debt expense to the sales in each accounting period.

Using the Allowance Method involves more accounting steps, and is more complicated both to understand and to operate. If you would like to learn more about this approach, you can read this article on the Accountancy Explained website.

Using the Allowance Method, an estimate for likely bad debts is made and updated in every accounting period. When an individual invoice is recognized as unrecoverable, instead of writing it off to Bad Debt Expense, it is written off to the Bad and Doubtful Debt contra asset account.

In Wave, you would process this write-off using the same two-step process via an 'Undeposited Funds' account as described above, except that in Step 2 you would categorize the transaction as Bad and Doubtful Debt (asset account); not the Bad Debt (expense) account.

If you feel that the Allowance Method could be more appropriate to your business, we encourage you to consult your accountant. Advising on the appropriate bases of estimation, and the detailed accounting steps required, is beyond the scope that Wave can advise on.