A bad debt expense is an expense recorded to account for a receivable that won't be collected.
By Rebecca Beam, Chief Finance Officer, Chargeback Gurus
Most merchants are not interested in becoming loan sharks. The expectation is that you’ll sell a great product for a fair price, and the customer will buy it and be happy. When a customer skips out on a bill for goods or services they’ve already received, it stings—but unless you’re willing to go to extraordinary lengths to pursue it, you eventually have to write these bills off as bad debt. As chargebacks can essentially be thought of as bills that become un-paid, it can be useful to account for them as a bad debt expense. What is a bad debt expense, and how do chargebacks factor in?
The concept of bad debt expense should be well familiar to business-to-business sellers and other merchants who invoice their customers under Net 30 or similar terms. Sometimes clients go out of business, staff turnover leads to disorganization, or disputes blow up, and an invoice never gets paid. For retail merchants who charge up front for the goods they sell, unpaid receivables aren’t quite so relevant to their day-to-day bookkeeping.
This may be changing as more merchants begin exploring installment payments and other in-house financing options, but for the average retailer, the most typical encounter with bad debt is in the form of chargebacks. Treating chargebacks as bad debt expenses, and accounting for them in a way that puts their impact on your revenue into context, can help you manage them more effectively.
What Is a Bad Debt Expense?
Under the accrual method of accounting, the bills and invoices you send to your customers are recorded as revenue when the sale occurs, rather than when they actually get paid. However, sometimes receivables don’t get paid for one reason or another. When you determine that a receivable will not be collected, it is no longer accurate to include it in your books as revenue. The way to deal with it is to record a bad debt expense that cancels it out. The transaction still counts as a sale, but because you cannot count it as revenue you have to charge it to an expense account.
The main purpose of bad debt expense recording is to ensure that your financial statements are prepared in accordance with GAAP—Generally Accepted Accounting Principles. While sole proprietor merchants may have only themselves and the IRS to answer to if they engage in haphazard accounting practices, it is very important to follow GAAP when you are preparing reports that will be viewed by executives, a board of directors, or financial institutions.
Any business that extends credit to its customers is at risk of incurring bad debt. Chargebacks are often overlooked in this process and not counted as bad debt—but they should be. The chargeback process effectively short-circuits the billing process, instantly transforming a paid receivable into an uncollectable one.
How Do Chargebacks Affect Bad Debt Expense?
Just because you lose revenue from a chargeback doesn’t mean that the money for the sale is no longer owed to you. You’ll likely never collect on a chargeback debt (although some merchants do try to sic collection agencies on friendly fraudsters), but by treating the chargeback as a bad debt expense in your books, you can provide more accurate reporting and revenue forecasting.
The other side of this is that by fighting chargebacks and increasing the amount of revenue you recover from invalid disputes, you can lower your bad debt and bring your estimated expenses down.
Why Do Merchants Need to Account for Bad Debt Expenses?
Accurate financial reporting helps businesses develop better long-term strategies. Whether it takes on traditional forms or shows up as chargebacks, bad debt can be a significant drag on a merchant’s income, but projecting it accurately can be a significant challenge. Omitting bad debt from your projections makes your financial statements unreliable, and can mislead the executives, board members, and even shareholders who need to use these reports as a basis for planning and decision-making. If the omission is large enough, it can even carry legal repercussions.
The way to avoid this is to estimate a bad debt allowance, which will save you from overstating potential income for the accounting period.
How Should Merchants Estimate Their Bad Debt Allowance?
Instead of writing off individual bad debts on a case-by-case basis, you can attempt to estimate and account for them ahead of time. This estimate can be recorded in your books as a bad debt allowance, and your bad debts can then be charged to this account.
There are various methods for estimating bad debt expenses for a given accounting period. One is to calculate it as a percentage of sales, based on historical results. If you experience high rates of chargebacks, you should be including them in your bad debt allowance. There are tools that can help you track and manage your historical chargeback data for this purpose.
GAAP requires the use of the matching principle, which states that expenses must be matched to the revenues they are related to in the same accounting period in which the sale that generated the revenue was made.
Take, for example, a company that sells 400 tablets at $1,000 each during the month of May. Their historical chargeback rate averages out to 0.5%. We can therefore estimate that two of those sales would turn into chargebacks for a loss of $2,000, and record that amount as the bad debt allowance for May. The actual chargebacks from any May transactions might not take place until June or even July, but to stay within the guidelines of GAAP and the matching principle, we would count them against income for the May accounting period.
Conclusion
You can add “makes my accounting more complicated” to the list of things to dislike about chargebacks, but accurate reporting and financial forecasting are important for the financial health of every merchant. Including chargebacks in your bad debt allowance ensures that you and everyone who reads your reports understand the actual impact of chargebacks on your bottom line. The true cost of chargebacks is not always a pleasant thing to reckon with, but when you understand the scope of the problem and are willing to tackle it with your best prevention and recovery efforts, you can win back lost revenue and lower your average chargeback rate.