Common accounting questions: How to handle bad debt
If you’re in business, you’re almost certain to encounter it eventually, so here’s how to handle bad debt from a business accounting perspective.
Perhaps a customer hasn’t paid you for your goods and services? Or maybe your business is involved in a loan that needs to be forgiven because your business or the other party can’t afford to repay the loan. These need to be written off.
There’s been a rise in these situations in recent years because of the economic volatility. Businesses find themselves stuck with cash flow constraints and are unable to pay debts when they are due.
So how do you handle bad debt from a business accounting standpoint?
What is a bad debt?
A debt is considered bad in the following circumstances:
- There must be a debt. In other words, there must have been an invoice raised that remains outstanding. Sufficient steps have been taken to recover the debt, and there is justification for no longer pursuing the debt as it has no likelihood of being recovered. Only then it is considered bad, and not doubtful.
- The debtor has died leaving no assets or insufficient assets.
- The debtor cannot be traced and no assets discovered.
- The debtor is bankrupt or in liquidation, and insufficient funds exist.
How do you account for a bad debt?
This depends on how you are recording your income in your business.
- Cash Basis: If you are recording income based on a cash basis, i.e., you recognise income in your accounting system only when it is banked into your business account, then there is no adjustment required for the bad debt as the debt would not have been included in your business income to date.
- Accruals Basis: If you are recording income based on an accrual basis, as in, you recognise income in your accounting system when it is invoiced, then the bad debt must be treated in your accounting system. Take the debt out of debtors or accounts receivable (this is another name for debtors) and recognise it as an expense called “Bad Debt” in the Profit and Loss Statement of the business. Note: a debt does not need to be written off in the year in which it first becomes bad; however, for the business to claim a tax deduction, the debt must be written off as bad in the income year it is being claimed. For example, if a debt has gone bad during the income year ended 30 June 2013, and you want to claim it that income year, it must be written off on or before 30 June 2013.
What issues should you watch out for?
- If the bad debt is later paid to your business after you have written it off, you need to include it as income in the income year the debt is recouped
- If there has been a change in ownership or control of the business, and the same business has not been carried on, you cannot deduct the bad debt
What happens when your debt/loan is forgiven?
In times when a business is in financial stress, a debt or loan can be forgiven.
When this does happen it’s important that you do the following:
- Have some documentation in writing to state the debt or loan has been forgiven
- Account for the forgiven debt or loan by writing off the debt out of debtors to an expense in the Profit and Loss Statement. Write off a commercial loan out of liabilities and recognise it as an extraordinary item in the Profit and Loss Statement
What are the tax implications when a debt/loan is forgiven?
When a debt or loan is forgiven, there are some tax implications. Also, some deductions will need to be reduced and others will be unclaimable.
- Carried forward tax losses will be unable to be claimed
- Carried forward capital losses will be unable to be claimed
- Depreciation on assets in the same income year that the debt or loan is forgiven must adjusted, and depreciation cannot be claimed
- Borrowing expenses cannot be claimed
Accounting treatment of bad debts and forgiveness of commercial debt and loans can be complicated. MYOB recommends you speak with an accountant to obtain his or her assistance and advice in dealing with these issues in your business.
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