Any business that allows customers to buy on credit is likely to end up with some customers who don’t pay their bills. To minimize losses from delinquent customers, you need to monitor your Accounts Receivable account closely and cut off any customer who does not pay within a reasonable amount of time. Most businesses block future charges to any account more than 60 or 90 days late.

Even if you’ve acted quickly to block future charges, you still must find a way to get your money or decide that the money is uncollectible. Remember that you have to pay taxes on profits the business makes, and you certainly don’t want to pay taxes on money the company will never receive.

You have to decide how long you want to wait until you determine an account is uncollectible. That amount of time could be 90 days, 120 days, or any number of days you determine is realistic for your business. Many companies review their accounts to search for ones that are uncollectible once or twice a year.

You need to add an account to track bad debt in your chart of accounts. You should place this account at the bottom of your existing chart of accounts and give it the number 6500.

For practice in recording bad debt, assume Lisa’s Candle Shop has a total of $1,500 that Lisa doesn’t expect she will ever collect from unpaid accounts in 2010. She records the loss in this way.

The Bad Debts account appears in the expense section of the P&L statement, and the Accounts Receivable account is reduced by the credit. In addition to this journal entry, the accounts receivable clerk needs to update the individual customer ledgers to show that the debt has been written off.

If at some time in the future the customer does repay the debt, you can reverse the entry very easily. Most likely the customer would pay in cash. Assume a customer who owed $100 came in to make the payment. You would record this payment of a bad debt as follows.

Even if the bad debts were written off in one year and paid in the next, the entry would be made in the year paid, and the P&L statement for the year paid would be the one adjusted because of this payment. After a customer pays his or her debt, you have to decide whether to allow him or her to use the store charge once again. You may decide to allow the account to be reopened, but with a red flag that blocks future charges as soon as the account is late 15 or 30 days so you don’t risk building another large bad-debt write-off. You also most likely would lower the customer’s allowable credit limit until he or she proves that payments will be made on time by maintaining timely payments for six months to a year.

The next chapter explains how to manage other types of expense accounts not related to sales activity.