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. In this scenario, you'll want to write off the invoice.
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.
Your business, Cottage Furniture, has a customer called Decorate Your Life. Decorate Your Life has gone broke, owing you $300.00 for inventory. They go out of business, and you know you're not going to get paid. Their invoice keeps showing up on your Dashboard as overdue, and just deleting it doesn't make sense, since you lost the inventory cost already. This would be the time to write off this invoice.
(If you use Wave Payments and someone paid you, but then you refunded the invoice and want to delete it, writing it off as described below will be the way to go. This is because, since real funds were moved on your business, a) writing it off best reflects the actual loss you experienced, and b) as your payment processor, this is a record of the money movement for you on your books. This is explained in more detail below the directions.)
Write off invoice to Bad Debt Expense
Right now, your bookkeeping includes $300 of income from Decorate Your Life. You have not actually been paid the money, so that is balanced by a $300 asset in Accounts Receivable - i.e. money you are owed. (This is because Wave invoicing is accrual-based.)
What we want to achieve is that the $300 Accounts Receivable asset 'disappears', and that we recognize the loss against your business income. Plus, you can stop seeing that 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 a created "bank account" that accountants traditionally refer to as a "clearing" account. A "clearing" account is simply an account in Wave that functions like a bank account, but doesn't represent a bank account that you have in the real world.
You create a "clearing" account exactly the same way you create any new account in Wave.
If you haven't previously created a clearing account, go ahead and create one now.
- Click Accounting > Chart of Accounts > Add a new account (top right corner).
- Create the new account under "Customer Prepayments and Customer Credits," and name it "Bad debt clearing account."
Writing off the invoice now involves two steps:
- First, mark the invoice as "paid:"
- Head to Accounting > Transactions > Add Income (top right corner)
- Under Description, enter something like 'Write Off Invoice ##' or something similar
- Under Account, choose the Bad debt clearing account you just made.
- Under Amount, enter the total amount you're writing off (in this example, $300)
- Under Category, choose 'Payment Received for an Invoice in Wave', then, choose the relevant invoice.
That's the overdue invoice and the Accounts Receivable balance taken care of!
- If you don't already have a Bad Debt Expense account, head to Accounting > Chart of Accounts > Add a new account (top right corner). Make the account type Operating Expense and make the account name Bad debt expense account.
- Head to Accounting > Transactions > Add Expense (top right corner)
- Under Description, enter something like 'Bad Debt on Invoice ##'
- Under Account, choose the Bad debt clearing account you made earlier.
- Under Amount, enter the total amount you're writing off (in this example, $300)
- Under Category, choose the Bad debt expense account you just made.
You now have $300 of Bad Debt Expense that offsets the $300 income from Decorate Your Life, your Accounts Receivable no longer shows an outstanding balance, and your Bad debt clearing 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:
- 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.
- 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. Alternatively, if you have added non-recoverable sales taxes to an invoice, you can remove the sales tax from the invoice before writing it off.
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:
- Your sales really did include the $300 to Decorate Your Life. The loss of that $300 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 $300 Decorate Your Life income is just a more accurate understanding of what happened in your business.
- 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!)
- 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.
If the invoice was paid and refunded through Wave Payments, you can't delete the invoice. That's because you need records of actual funds moved by us, your payment processor.
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 Coach 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 a 'clearing' 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.