The InvoiceSherpa Blog

How to Write Off Uncollectible Accounts Receivable (and Avoid Them in the Future)

Every business owner knows the sting of an unpaid invoice. It’s beyond frustrating and leaves you feeling disrespected and uncertain of your options. 

Not only do uncollectible accounts receivable disrupt your financial planning, but they also shadow the growth potential of your company. They leave you with a sour taste in your mouth and can ruin relationships you’ve worked tirelessly to build with clients.

But what if there were a way to not only handle these stubborn entries effectively but also prevent them in the first place? We’ll walk you through how to write off uncollectible accounts receivable below. 

More importantly, we’ll empower you with tips on avoiding the frustration of uncollectible receivables altogether by leveraging our accounts receivable automation software here at InvoiceSherpa. But first, what does uncollectable accounts receivable mean exactly? 

What Does Uncollectible Accounts Receivable Mean?

Uncollectible receivables refer to money that a business is owed by its clients but, due to various reasons, is unlikely to be collected. 

It's essentially revenue you counted on but will probably never materialize. You already incurred costs of delivering a product or service, which makes matters worse. You’re not just losing revenue - you’re incurring a loss. 

Impact on Business Financials

Uncollectible accounts create ripple effects in your business financials. They skew your revenue projections, lead to discrepancies in financial reporting, and can even mislead stakeholders about the company's financial health. 

An accumulation of such accounts over time can erode profitability, disrupt cash flow, and pose significant challenges in planning and executing growth strategies. 

That’s why you can’t just ignore this issue and chalk it up to “part of the game of business”. You must be proactive in handling them promptly as well as working to prevent them in the first place.

Difference Between Bad Debt and Uncollectible Accounts

We need to distinguish between bad debt and uncollectible accounts before venturing any further. These terms are often used interchangeably, but there's a subtle difference between them.

Bad debt is money that a company has already recognized as revenue but later realizes will not be collected due to customer default. It's recognized as an expense on the income statement.

On the other hand, uncollectible accounts are amounts that, after prolonged efforts, are deemed uncollectable. These are not yet recognized as expenses, as you’re still clinging to the hope of being collected. These too might transition into bad debts over time if efforts remain unsuccessful.

Common Reasons for Uncollectible Receivables

There are inevitable crests and troughs in the ebb and flow of business finances. Uncollectible receivables often represent a painful trough and a blow to anticipated revenue. 

But what pushes an account into this dreaded category? Ultimately, uncollectible receivables fall into one of two reasons: your client can’t pay or they won’t pay.

Client Bankruptcy: When Clients Can't Pay

Client bankruptcy is one of the primary reasons for uncollectibility. Filing for bankruptcy typically means the client is legally unable to fulfill their debt obligations. 

Even if they want to settle the amount owed to your business, their hands are tied by legal and financial constraints. 

Such scenarios can leave businesses grappling with substantial revenue loss, especially if that client constitutes a significant portion of their receivables.

Disputed Charges: When Clients Won't Pay

Sometimes, it's not about the ability to pay, but the willingness. Disputes over the quality of products, services, or misunderstandings about contract terms can lead clients to withhold payment. 

These disputed charges can linger if not addressed promptly, turning into longstanding uncollectible accounts. Fortunately, this is where you have more power to collect on the amount owed to you.

Flawed Credit Policies

Not all uncollectible receivables result from external factors. Sometimes they're homegrown. 

Businesses with lenient credit policies or those that lack a rigorous vetting process for clients might find themselves juggling a higher number of uncollectible accounts. 

Offering credit without adequate checks is akin to flying blind, exposing the business to avoidable risks. We’ll talk about revamping your credit policies later on as a means of avoiding this issue in the future. 

Economic Downturns

Broad economic factors play their part too. Businesses might experience an uptick in uncollectible accounts during economic recessions or industry-specific slumps. 

Clients might delay or default on payments as they face their own financial challenges. While individual client issues can be addressed, widespread economic downturns require a broader strategy, emphasizing understanding, flexibility, and proactive communication.

How to Write Off Uncollectible Accounts Receivable

Uncollectible accounts receivable can be a thorn in the side of any business's financial health. But while it's frustrating to confront the idea that you’re never going to see the money you are owed, it's crucial to handle these write-offs correctly to maintain clear and accurate financial statements. 

There are two ways you can go about it - the direct write-off method of accounting for uncollectible accounts or the allowance method. We’ll break both down below and help you choose the right approach. 

The Direct Write-Off Method of Accounting for Uncollectible Accounts

This approach is straightforward. When it's evident that a particular account is uncollectible, you write it off as an expense immediately. The specific account is removed from the accounts receivable, and an equivalent amount is recorded as a bad debt expense.

Journal Entry:

This method is simple, but its drawback is that it doesn't follow the matching principle of accounting. Expenses aren't matched to the revenues they're associated with which can lead to a tangled, confusing mess down the line.

The Allowance Method: Setting Aside for Expected Losses

Businesses can use the allowance method to set aside a specific amount as a provision if they anticipate that some accounts might become uncollectible in the future. This method involves estimating the amount that won't be collected and adjusting the books accordingly.

Journal Entry:

An account is then written off against the allowance if it is in fact deemed uncollectible, which would look like this:

Journal Entry:

This method aligns better with the matching principle since businesses estimate bad debts in the same accounting period as the sales occur. 

Understanding the Impact of Uncollectible Receivables on Your Balance Sheet and Income Statement

Whichever approach to writing off uncollectible accounts receivable you choose it’s important to be aware of the impact on your financial statements. 

Take your balance sheet for example. You’ll see a decrease in accounts receivable and total assets upon writing off an uncollectible account. However, the impact on your income statement is dependent on which write-off method you apply.

Under the direct write-off method, bad debt expense is recognized, reducing the net income. With the allowance method, the bad debt expense affects the net income when the allowance is created, not when a specific account is written off.

Legal Remedies and Collections Agencies in Navigating Uncollectible Accounts Receivable

While understanding the reasoning behind uncollectible receivables and writing them off is one part of the equation, actively recovering those debts is another. 

Navigating the terrain of collections and legal action can be daunting, but it's essential to be informed. Here’s when taking legal action might make sense for your company…

When to Consider Taking Legal Action

It’s important to realize that not every unpaid invoice warrants a date in court. It's essential to set a threshold. If the amount owed surpasses a particular figure, which severely impacts your business, it may be time to involve legal counsel.

You should also take time into account. Patience and repeated reminders might bring in the money sometimes. However, it's wise to reconsider your approach if it’s been several months or even a year with no promise of payment.

Above all else you should consider the client relationship itself, recognizing the strain that legal action places on it. Legal action might get you your money, but it might also end a business relationship.

Assess the long-term value of the client. If it’s a one-time issue with a long-standing client, legal action might not be the best course. That being said, how do collections agencies fit into the puzzle?

Pros and Cons of Collections Agencies

Hiring a collections agency is like hiring a bounty hunter in the business sense. They are well-versed in debt recovery as they know the strategies and methods that yield results. Hiring an agency maximizes the chances of retrieving the outstanding amount. 

Plus, chasing unpaid invoices can be time-consuming. Outsourcing this task means you can focus on core business activities. Reputable agencies are aware of the legalities surrounding debt collection, ensuring that all recovery efforts are within the boundaries of the law.

However, it’s paramount that you’re aware of the downside that comes with using collections agencies. There is the obvious cost of hiring them, represented by either a flat fee or a percentage of the amount collected. Either way, you’re not getting the full amount owed.

This also goes back to considering the relationship between you and the client. The tactics employed by some agencies can be aggressive, which could strain or sever your relationship with the client. 

But if it’s gotten to this point, chances are, you don’t care about the relationship either (and continuing the relationship would be bad business sense anyway, as they’re proven to be an unreliable client).

And at the end of the day, there is no guarantee of payment. There's a chance you might spend on their services and still not recover the debt. 

All of this is to say that it's crucial to strike a balance in your pursuit of unpaid accounts. Sometimes, you’re better off taking the loss and revamping your policies to avoid uncollectible receivables in the future.

Advice on Avoiding Uncollectible Receivables in the Future

Nobody starts a business expecting not to be paid for their hard work. But it’s still something you need to prepare for with strategic policies and careful vetting. Here are some strategies to significantly reduce the chances of being left with unpaid invoices.

Vetting Clients More Carefully Prior to Onboarding

It's essential to check the financial health and reputation of a prospective client before entering a business relationship. This doesn't mean being suspicious but being prudent. 

Obtain references, check with other businesses they've worked with, and look into any past financial issues. A bit of initial diligence can prevent a lot of future headaches.

Enhance Credit Policies by Tightening Your Credit Approval Process

It might be tempting to extend credit easily to attract more clients. Still, a loose credit policy can leave you vulnerable. That’s why you must regularly review and update your credit policies. 

Consider shorter payment terms, requiring deposits, or setting a credit limit for new clients until they've established trustworthiness.

Prompt and Regular Follow-ups

Clients just forget to pay sometimes. They’re busy just like you and are constantly being pulled in different directions. 

Thus, a systematic reminder system can help prevent invoices from aging into uncollectible territory. This could be as simple as sending email reminders or statements at regular intervals. 

We’ll talk later on about how InvoiceSherpa can help you with this and some of the other benefits of accounts receivable automation you’ll enjoy with our software.

Offer Multiple Payment Options

There are countless ways to transact in today's digital age, and you reduce friction by providing a range of payment methods. After all, the easier and more convenient you make it for clients to settle their dues, the better odds you have of capturing payment!

This can include anything from online transfers to credit card payments or even digital wallets. Again - InvoiceSherpa can empower you to offer an array of payment methods for your clients to help with this.

Stay Updated on Client Financial Health

Businesses evolve, and so do their financial situations. A client that was financially stable a year ago might be facing challenges now. So, regularly review the financial health of your long-term clients. 

This doesn't mean prying into their business but maintaining open communication. If they're facing a rough patch, you can work together to find a solution before the account becomes uncollectible.

By incorporating these strategies into your accounts receivable management, not only do you reduce the risk of uncollectible receivables, but you also foster better client relationships. And, much of this can be automated through our intuitive software at InvoiceSherpa…

Make Uncollectable Accounts Receivable a Problem of the Past With InvoiceSherpa and Get Paid On Time!

The days of tirelessly chasing unpaid invoices and navigating the murky waters of uncollectible accounts can be behind you with InvoiceSherpa by your side. Your accounts receivable process transforms from a painstaking task into a streamlined, efficient, and even rewarding process. 

Forget about manually sending reminders to every client. InvoiceSherpa sends out timely, polite, and professional reminders to your clients, ensuring that your invoice remains a priority. 

Not only does this save you an incredible amount of time, but it also reduces human error, ensuring no client is overlooked. You can customize these messages to your liking to stay on brand.

Communication is at the heart of any good business relationship. Our platform offers tools that facilitate clear and consistent communication with clients. Your client gets their own portal to view any outstanding invoices and even make payment terms if necessary.

Plus, you can eliminate uncollectible accounts receivable altogether by setting up automatic, recurring payments when possible to auto-bill clients on a routine schedule. The system integrates with the most popular accounting software - like Quickbooks, Clio, and Xero.

Knowledge is power. You have access to real-time insights into your accounts receivable with InvoiceSherpa. Which clients are consistently late? Which invoices are nearing their due date? 

You can make informed decisions with these insights, from following up with specific clients to revising credit terms. 

Compared to outsourcing accounts receivable, you can save time, money, and headaches with automation instead. Try InvocieSherpa for free over the next 14 days and discover firsthand what a difference it can make in helping you avoid uncollectible receivables in the future!

Parting Thoughts on Uncollectible Accounts Receivable

Uncollectible accounts receivable can trip up even the most seasoned professionals. These outstanding balances represent real challenges, potential risks, and missed opportunities. 

But with the right strategies and tools, you can minimize their impact, ensuring smoother cash flow and firmer financial footing. Our blog has additional resources on why cash flow management matters, calculating accounts receivable, and more.

Remember as you venture forward that while challenges will arise, solutions are always within reach. InvoiceSherpa offers a smart, tech-driven approach to navigating the complexities of AR, ensuring you stay ahead of potential pitfalls. 

Don't let uncollectible accounts receivable dictate your business narrative - take control by giving InvoiceSherpa a try today!

Posted on October 2, 2023

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