Accounting

What is Bad Debt?

Bad debt is money owed to you that you can't collect - typically when a customer doesn't pay and you write off the invoice.

Example

Customer owes £5k, goes bankrupt, can't pay. You write it off as bad debt, reducing your taxable profit.

Key Dates

Can reclaim VAT on bad debts over 6 months old

How Bad Debt Works in Practice

A bad debt is an amount owed to your business by a customer that you determine is unlikely to be collected. This can happen because the customer has gone into liquidation, is disputing the invoice, has simply disappeared, or has been chasing for so long that it is no longer commercially viable to pursue. When you write off a bad debt, you are acknowledging that the money is lost and removing it from your accounts receivable.

Bad debts have two important tax consequences. First, for Corporation Tax (or Income Tax for sole traders), the amount of the bad debt is an allowable expense that reduces your taxable profit. You can only deduct a bad debt that has been included in your turnover and that you have genuinely written off in your accounts. HMRC may challenge write-offs if the debt is owed by a connected party or if you have not made reasonable efforts to collect it.

Second, for VAT purposes, you may be able to reclaim the output VAT you originally paid to HMRC on the invoice that was not paid. This is called 'bad debt relief'. To qualify, the debt must be at least six months old from the date it became due, you must have already accounted for the VAT on a previous return, and you must have written the debt off in your accounts. The relief is claimed by including the VAT amount in Box 4 (input tax) of your VAT return.

It is good practice to distinguish between 'specific' bad debts (identifiable invoices you have written off) and a 'general provision' for doubtful debts (an estimate of how much of your total debtors may not pay). For Corporation Tax purposes, HMRC only allows specific bad debt write-offs as a deduction, not general provisions. However, for your management accounts, a general provision gives a more realistic picture of your financial position.

Step by Step

The process for writing off a bad debt typically involves several steps. First, you exhaust your credit control procedures -- send reminders, make phone calls, and issue formal demand letters. Document every step. Second, if the customer still does not pay, you make a commercial decision to write off the debt. This should be approved by a director and documented in a board minute or management decision.

In your accounting records, you debit 'bad debt expense' (which appears in your profit and loss statement) and credit 'accounts receivable' (which reduces the asset on your balance sheet). The net effect is a reduction in profit equal to the amount written off. If you previously accrued for the debt in a 'provision for doubtful debts', you debit the provision account instead.

For VAT bad debt relief, you must keep specific records: the time and amount of the supply, the VAT period in which you originally accounted for the output VAT, the date and amount of any payments received, a record of the amount written off, and proof that the debt is at least six months overdue. You must also keep the claim details for six years after the end of the prescribed accounting period.

Practical Tips

Set up a regular review cycle (monthly or quarterly) to identify overdue invoices and decide which to pursue and which to write off
Keep a paper trail of all collection efforts -- emails, letters, phone call notes -- as evidence for both tax deduction and VAT relief claims
Set up a diary note for the six-month anniversary of each overdue invoice so you can claim VAT bad debt relief as soon as possible
Consider credit insurance or upfront payment terms for new customers to reduce bad debt risk in the first place

Common Mistakes to Avoid

Claiming a Corporation Tax deduction for a general provision rather than specific identified bad debts -- HMRC only allows specific write-offs
Not claiming VAT bad debt relief after six months -- many businesses forget this entitlement and effectively pay VAT on income they never received
Writing off debts to connected parties (such as another company you own) without genuine commercial justification -- HMRC will challenge these
Failing to keep adequate documentation of credit control efforts, which HMRC may request as evidence that the write-off is genuine

Frequently Asked Questions

When should I write off a bad debt?

Write off a debt when you have exhausted all reasonable collection efforts and there is no realistic prospect of recovery. There is no fixed time period, but debts over 90-180 days past due are commonly reviewed for write-off. For VAT relief, the debt must be at least six months old.

Can I reclaim the VAT on a bad debt?

Yes, provided the debt is at least six months past the due date, you have written it off in your accounts, and you originally accounted for the output VAT on a previous return. Claim the relief by including the VAT in Box 4 of your VAT return.

What if the customer pays after I have written off the debt?

If you receive payment after writing off the debt, you must reverse the write-off. The payment becomes taxable income again, and if you claimed VAT bad debt relief, you must repay the VAT to HMRC in the VAT period you receive payment.

Is a doubtful debt the same as a bad debt?

Not exactly. A doubtful debt is one where you think collection is uncertain but still possible. A bad debt is one you have given up on and formally written off. You can make provisions for doubtful debts in your management accounts, but only write-offs of specific bad debts are tax-deductible.

Source: HMRC Business Income Manual (BIM42700+) for bad debt deductions: https://www.gov.uk/hmrc-internal-manuals/business-income-manual/bim42700 and VAT Notice 700/18 for bad debt relief: https://www.gov.uk/guidance/claim-a-vat-refund-for-bad-debt-vat-notice-70018

Related Terms

Accounts Receivable (Debtors)

Accounts receivable is money owed to your company by customers who haven't paid their invoices yet. Also called debtors or trade debtors.

VAT (Value Added Tax)

VAT is a tax added to most goods and services sold in the UK. Businesses collect it from customers and pay it to HMRC, minus any VAT they've paid on business purchases.

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