We find people are often surprised to learn that you are supposed to record income before you receive the cash. To quickly review, an account receivable is set up using an invoice in QuickBooks. The invoice will record income and a receivable as of the date services are provided or as of the date a gift commitment is made. Most of the time, these future obligations are fulfilled by the customer or donor. But what happens when someone does not pay?
A Tale of Old Pledges
Once we had a client with about $50,000 in pledges receivables on the books. We kept asking the executive director if she thought the pledges were good because they had not received a payment on most of them for a long time. “Oh those pledges are good. We are calling the donors. We don’t need to write any off,” she assured us.
In the end, nearly all of those pledges had to be written off. We believe the reluctance to write them off was because doing so would cause bad debt expense which would make the profit and loss report show a loss. Unfortunately the uncollectible receivables had not been addressed more realistically in prior years and had accumulated into a big “loss avalanche!”
Bad Debt Expense
Sometimes people don’t pay and you must write off the amounts they owe. The question is when do you take the hit for the bad debt expense. What you hope to avoid is recognizing income in one year and having to write off that income in a later year as bad debt. You want the income and any related bad debt expense to be recorded in the same year. That’s the point of using an account called “Allowance for Doubtful Accounts.”
Allowance for Doubtful Accounts
The Allowance for Doubtful Accounts is a contra asset to the Accounts Receivable and Pledges Receivable accounts. That means it reduces the total amount of accounts receivable. Each year, you want to estimate the portion of receivables that will not be collected. Here are two ways to go about making such an estimate:
- Consider historical default rates, such as write offs you typically encounter on pledges made at a special event.
- Consider the individuals behind each pledge. Do you have any knowledge that leads you to believe certain pledges will or will not be paid?
Based on your evaluation of the collectability of your receivables, you can then set up an allowance for bad debt. The journal entry records expense to the Bad Debt account with an offset to Allowance for Uncollectible Accounts. In the future if an account becomes uncollectible, you write it off to the allowance account and the bad debt expense will not impact your books that year. That’s because the expense was recognized in a prior year when the allowance was recorded.
The other option, if you do not have an Allowance for Bad Debt or if you did not record a big enough allowance, is to write off the receivable directly to Bad Debt Expense. Then you will show bad debt expense in the current fiscal year.
Receivables Accounts in QuickBooks
QuickBooks Online only allows you to have one accounts receivable account. This one account has to suffice for trade receivables, pledges receivable and grants receivable. You can set up an allowance account as an Other Current Asset account, which may be easiest. In QuickBooks Desktop you can have a separate accounts receivable account for each type of receivable and the allowance for doubtful accounts. Then the allowance account can be netted with the total of receivables on the balance sheet.
Clean up Bad Accounts
By staying on top of your accounts and pledges receivable using the tips in the last two blog posts (as referenced at the top of this post) and contacting people promptly if they fall behind, you can minimize bad debt. But you likely cannot eliminate it. If you have receivables, you will need a strategy for recording bad debt, and, ultimately, writing off those accounts that will never pay. By keeping your receivables squeaky clean and recording a realistic allowance for doubtful accounts, you can enjoy a snowfall of income and avoid experiencing a bad debt avalanche.