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Know About Bad Debts and Their Impact on Business Assets

Posted by : Whiz jackjohnusa90@gmail.com on Jun 28,2022 05:12 PM
Know About Bad Debts and Their Impact on Business Assets

Today, many businesses offer to sell goods on credit to their customers to attract and retain them with flexible payments. Credit sales are mandatory for many industries, especially where companies require urgent supplies to produce or sell. Credit sales allow customers to gather the required money for the given time and pay for the supplies. The firms following this method have to maintain an accounts receivables department. The accounts receivable activity allows companies to extend credit sales and collect customer payments within due time. The outsourcing accounting companies provide cost-efficient and effective ways to handle these services. 

The primary risk of extending credit sales to customers is not receiving the payment. Businesses record their transactions in the receivables, and the clients become the business's debtors on the balance sheet. As soon as the debtors pay their dues, they get removed from the balance sheet until the next transaction. However, every customer does not always honor its obligations. Often, companies have to struggle and put a lot of effort into collecting client payments. They can cross their due dates and still not pay. In such cases, the accounts receivable services follow utmost caution in preventing these debts from becoming bad. 

What do you mean by bad debts?

Bad debts is an accounting term that signifies that debtors can no longer pay their dues. It occurs when the customer refuses to pay or cannot clear the payments. It can also happen when disagreements arise over the products and services sold. The customers may have gone bankrupt because of which they cannot clear their payments. After taking diligent steps to recover the amount, the firms report this in their books. 

Why do bad debts occur?

Bad debts occur due to the following reasons:

·       Adequate credit and background checks did not happen before extending credit to the customer
·       There is an economic recession
·    The company did not undertake diligent efforts in getting payment from customers
·       The customer is not ready to make payments
·       The customer went insolvent or is facing significant financial problems

Bad debts reported in the books of accounts- 

The outsourcing accounting services record bad debts under the accounts receivable management process. Bad debts occur due to credit sales and thus are a part of these services. For accounting purposes, companies follow two procedures:

Direct reporting involves deducting the bad debts that occurred directly from the debtors' section recorded on the assets side of the balance sheet.

Under the allowance method, firms follow the prudence principle. It involves estimating losses and not profits. The firms prepare a provision which is an estimated value of the bad debts firms expect to incur. It stands as a liability on the balance sheet. It reduces when the actual bad debts get deducted from it. 

Impact on business assets:

It reduces the business assets by the number of bad debts incurred. The bad debts affect the firm’s current assets, which are short-term for the firm. These indicate poor financial performance and the health of the firm. 

The outsourcing accounting services show how bad debts lead to the following-

Reduced cash flow:

It reduces the cash available to pay the clients. Unrecoverable amounts lead to instability in business accounts.

Decreased profitability:

The firm's ability to make profits decreases considerably due to bad debts. These debts get debited in the income statement, reducing the firm's profits.  

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