Periodically, you will need to write off bad debts, that is, declaring invoices to be non-collectible and removing them from your Accounts Receivable and from your previously stated income.
Consult with your accountant and/or attorney about the pluses and minuses of each of the methods below to determine the best method for your business.
For any method that you choose, you will set up accounts. Please consult with your accountant to assure you set up the accounts correctly.
When an Invoice becomes non-collectible, write it off. However, this can lump bad debt into one period and does not match expense to income.
You can record a bad debt with a Credit Memo or Journal Entry. This how you use a Credit Memo:
Receiving a payment for a debt that has been written off as uncollectible creates a credit balance in the customer's account that you must adjust. There may be tax implications so please consult with your accountant or attorney regarding the tax implications for your situation.
Generally accepted accounting principles (GAAP) recommend using the allowance method to manage bad debt if you are using accrual accounting. Each time you invoice customers, you debit a portion of the income to Bad Debt Expense and credit the same amount to Allowance for Bad Debts. When you write off a bad debt, you credit A/R and debit Allowance For Bad Debts. You would use this method for three reasons:
When you use cash basis accounting, you do not have bad debt because your customer has not paid you and you have not recorded income from the invoice. However, if you are entering accrual transactions (invoices), then you may want to clear your Accounts Receivable invoices that will not be paid.
You have some options:
What you do not want to do is to enter a credit memo or a journal entry or a discount reversing the invoice. When you link the reversing transaction to the invoice, you are recognizing income that you do not have and an expense you did not incur.
When you have a partially paid invoice, the options above do not work: you cannot void the invoice and you cannot make the invoice pending. But you do have an option: