Bad debt
An amount a customer owes that the business no longer expects to collect, written off as an expense.
In short
- Under accrual accounting, expected bad debts are usually estimated in advance through an allowance.
- In Canada, a bad debt can generally be deducted for income tax once it is established as uncollectible.
- The GST/HST charged on a written-off invoice can often be recovered.
A bad debt is a receivable that will not be paid. The customer may have gone out of business, disputed the charge, disappeared or simply refused to pay, and further collection is not worth the cost. The amount is removed from receivables and recorded as an expense.
Two ways to record it
- Allowance method: the business estimates, each period, how much of its receivables will not be collected, and records that estimate as an expense and an allowance for doubtful accounts. When a specific invoice is written off, it is charged against the allowance. This is required under most accounting standards because it matches the expense to the period of the sale.
- Direct write-off method: the expense is recorded only when a specific invoice is written off. It is simpler but can put the expense in a later period than the sale.
Tax treatment in Canada
For income tax, a business can generally deduct a debt that it has included in income and that it establishes has become uncollectible, and it can claim a reasonable reserve for doubtful debts. For GST/HST, a supplier that writes off a receivable can usually claim back the tax portion of the bad debt. If the customer later pays, the recovered amount and the tax on it have to be added back.
Bad debts are often a sign of weak credit checks or slow collection. Tightening both is cheaper than writing off revenue.
Worked example
A customer goes under
A wholesaler is owed $11,300, including $1,300 HST, by a retailer that has declared bankruptcy. The trustee indicates unsecured creditors will receive nothing. The wholesaler writes off the $10,000 against its allowance for doubtful accounts, deducts it for income tax and claims back the $1,300 of HST it had remitted on the sale.