What is Bad Debt?

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.

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.