Bad debt is a form of expense that is no longer considered collectable at the time of repayment by a customer. In other words, it’s an irrecoverable bad debt.
Bad debt is a money lost by the organization and shown as an expense in an income statement’s debit side.
Under the following conditions, they arise:
- If a business offers too much credit to a customer who is incapable or unable to re-pay the debt, results in either a postponed, diminished, or missed payment.
- When a client misrepresents itself to obtain a sale on credit and has no intention of re-paying the seller.
The first circumstance is due to inadequate organizational procedures or changes in a customer’s ability to pay. The second circumstance is induced by a client deliberately engages in fraud.
For example
Michael’s company sells handmade chairs at the cost of £ 350 each. Michael sells £ 5,000 worth of goods to XYZ Ltd at 90 days credit.
However, XYZ Ltd files for bankruptcy after 90 days, and it is apparent that they are unable to pay the due amount of £ 5,000 bill.
So, the due amount of £ 5,000 is considered bad debt as it is no longer recoverable.
If the same has been irrecoverable in the preceding financial year, then business and profession will be eligible for a deduction. However, the debt must be reported and written off to be tax-deductible, and it is essential to make reasonable efforts to recover the debt.
Judicial action will have to be taken in debt of a large amount before the debt is declared bad.
The debts owed by associated parties, such as family members, business partners or shareholders, are not tax-deductible.
Bad debts provision
An accounting procedure that allows an individual to estimate the amount of bad debt they need to write off in any specific period is called bad debt provision or allowance. It is also known as provision for doubtful debts.
When an individual realizes that debtors will not pay that portion of the debt, he should record the same in provisions account.
Later, when he collects the sum, then deduct it from the provisions account. He would consider them bad if he doesn’t obtain the full amount and then write off. The record essentially offers a clear picture of the debtors who are yet to be receivable.