Uncollectible AccountsWhat are they and how to protect your business from them

When extending credit sales to your customers, there’s always that worry of whether you’ll receive payment or not.

It might not be a problem if you know your customers well and know for certain that they’ll pay.

However, the expansion of your business comes with a wave of new customers, possibly ones you haven’t dealt with before.

Since you don’t have a transaction history with these new customers, you can’t be certain whether they’d pay or not.

Granting credit comes with the inherent risk of a debtor not following through with his/her promise of payment.

If it’s determined that collection cannot be done, that’s when a receivable becomes an uncollectible account or bad debt.

However, that does not mean that you’ll just accept such risk and not do something about it.

While it is true that some receivables inevitably become uncollectible, there’s still a lot that you can do to prevent that from happening.

The assumption that “if a customer owes a debt, they have to pay it” isn’t necessarily wrong.

When you owe someone, particularly money, you are obligated to pay them.

However, just relying on this assumption without doing the “active” part of the collection process is what allows for uncollectible accounts to accumulate.

The more a business passively waits for its receivables to be paid, the higher the risk of such receivables becoming delinquent.

In this article, we will discuss what an uncollectible account is, why it accumulates, and how it affects your business.

Along with that, we’ll also discuss the many ways to protect your business from the accumulation of uncollectible accounts.

What are uncollectible accounts?

Uncollectible accounts are receivables (e.g. accounts receivable, loans receivable, notes receivable) that are deemed to be no longer collectible.

If a business cannot collect a certain receivable even after exhausting all available options, then it can safely consider the receivable to be an uncollectible account.

These assets (if you can even call them that) are virtually worthless and should be written off.

Uncollectible accounts are also referred to as bad debts.

There are many reasons as to why a receivable becomes an uncollectible account:

• The customer who owes the business is on the verge of becoming bankrupt or is already bankrupt
• A defective product was sent to the customer which is why they refuse to pay unless they receive a replacement
• The customer is experiencing liquidity issues and is requesting an extension of the credit term; in this case, payment is only delayed, but the risk of bad debt is higher than normal because of the aforementioned liquidity issues
• The customer is refusing to pay just because; this happens when credit is granted is to any customer without performing a credit check; there is a chance that credit can be granted to a customer who doesn’t have the intention to pay from the very start (even if they can)
• Receivables, particularly accounts receivable, came from a bogus sale; this means that there is no actual sale and there’s no actual customer to collect from; the receivable was uncollectible from the very start
• The customer cannot be reached and is actively avoiding the business
• There is no credit policy in place, or if there is one, its implementation is weak (e.g. any employee is allowed to grant credit, credit checks are not performed, there are no clear credit terms, etc.)

How the accumulation of bad debts affects your business

Whatever the reason, an uncollectible account is still an uncollectible account.

The result will always be your business having a worthless asset.

As such, the accumulation of uncollectible accounts must be minimized, if not totally avoided.

If left on their own to accumulate, the effect they have on your business could lead to many issues.

Here’s how the accumulation of uncollectible accounts negatively affects your business:

• A reduction of the net realizable value of receivable; since uncollectible accounts are worthless assets, they have zero realizable value
• If the level of uncollectible accounts is already at a high level, the business might become insolvent or even bankrupt
• Reduces the amount of expected cash flow which can disrupt the cash plan of the business
• The possibility of losing the trust of investors due to the inability to collect receivables
• Might result in not having enough liquid assets (cash) to pay off debts and other payables
• Paints a picture of your business being incompetent to your employees, customers, supplies, and/or the community as a whole
• Overstates your revenue; May require your business to re-evaluate its projected revenues as its probable that they are overstated too

The accumulation of uncollectible accounts must be controlled to minimize their effect on your business’s financial health and even existence.

Having a strong and well-functioning credit policy is just one step to having fewer uncollectible accounts.

How to minimize uncollectible accounts

While entirely removing the inherent risk of granting credit is close to impossible (especially for a growing business), it doesn’t mean that you can’t reduce it.

In fact, reducing credit risk is essential if you want your business to have good quality receivables.

As already mentioned, having a strong and well-functioning credit policy is just one step towards that.

Here are some procedures that you can take to protect your business from the accumulation of uncollectible accounts:

Always credit check your new customers

Especially ones that don’t have a transaction history with businesses similar to yours.

Credit checks must always be done before granting credit to new customers.

It is to ensure that the customer has the capacity to pay, and more importantly, has the intent to pay.

That’s not to say though that credit checks are exclusive to new customers.

You can also perform credit checks on existing customers, especially if there are indicators that their financial conditions have changed.

For example, an existing customer that always pays on time had been late in paying their previous debt.

This could be a prompt to perform a credit check on that particular customer before granting credit.

Clearly state your terms and conditions on the contract or any form of business documentation

While it may sound outlandish, some of the reasons why a customer won’t pay are that they don’t know what they’re paying for, when they should be paying, and/or how much they should be paying.

Clearly stating your terms and conditions can address that issue.

Include in your contract or documentation the terms of payment for the credit sale such as when it becomes due and if there are penalties and late fees for late payments.

For example, you may state that all credit sales must be paid within 30 days from the date of sale and that late payments will be charged a late fee of $50 (flat-rate).

This makes it clear to your customer when they should pay to avoid incurring unnecessary expenses.

You can take it a step further by posting your terms and conditions on your business’s website (if it has one).

Consider requiring downpayment for credit sales

We’re talking about having a certain percentage of the sale be paid upfront.

It could be included in your terms and conditions, or you could make it on a case-to-case basis.

For example, you might want to require a downpayment of 25% for credit sales that are at least $10,000.

Or you might want to require downpayment for new customers or existing customers that had delinquent accounts before.

The purpose of having upfront payments is to reduce the amount owed by your customers.

That way, even if a customer defaults on the credit sale, you still collect a portion of it so it’s not entirely a loss.

Offer discounts and/or incentives for upfront cash payments or early payment

Offering incentives for early payments might encourage your customers to pay before the due date.

You may lose a portion of your earnings due to the discount, but the payoff of securing early payments more than makes up for it.

That way, you would be accumulating lesser uncollectible accounts since your customers would want to make earlier payments because of the discount.

For example, you may include in your terms the following: 2/10, n/30 which means that the credit sale is due within 30 days, and a 2% discount is offered for full payments made within 10 days.

Promptly send invoices and billing statements; make sure that they are correct too

Sending invoices as soon as the delivery of the service or product signals to your customers that you are serious with your credit collection.

Just make sure that they are accurate and sent to the correct address – you wouldn’t want to have a customer complaining about a wrong invoice.

Invest in customer relationships

It doesn’t always have to involve money.

It could be as simple as including a thank you card with their every purchase, or a phone call asking how they are doing.

Customer relationships are just like any other relationships – they need to be worked on.

When you have strong relationships with your customers, they are more inclined to pay you their dues.

This is because they would want to support your business, and not paying on time or not paying at all can ruin that.

Plus, you’re more likely to know the financial condition of your customers if you stay in touch with them.

This can then help in designing special credit terms to better accommodate their situation.

Chase payment immediately when a receivable becomes or is about to become overdue

When a receivable is about to become overdue, immediately chase after it!

Send written reminders, emails, make phone calls, send a representative to remind them their due– anything to communicate to your customers that you are serious about collecting credit.

Doing so will make customers less inclined to think that they can choose to not pay their debt and expect to get away with it.

That potentially reduces the accumulation of uncollectible accounts.

Conclusion

Uncollectible accounts are receivables that virtually have no value.

In other words, they are worthless assets.

They overstate your assets, leading to financial statements that aren’t accurate.

They also signify weakness in the business’s credit and collection procedures.

Overall, your business is better off not having them.

As such, it is in your best interest to protect your business from them.

Having a strong and well-function credit policy is just one step towards that.

Having several safeguards from uncollectible accounts helps in reducing the inherent risk of granting credit.

At the end of the day, the accumulation of uncollectible accounts depends on how you handle your receivables.