Bad debt tax treatment

I am a freelancer working through my own company and my year end is 30th September 2017. During June 2017 I invoiced a client for some work and they have still not paid me – I have chased this up on numerous occasions but don’t seem to be getting anywhere and I have heard through the grapevine that they may be in financial trouble so I think there is a strong chance I won’t get paid for this invoice.

How do I treat this in my year end accounts and how will things change if I do get the payment from them further down the line? I am not VAT registered.


Bad debt tax relief


Answer Dec 2017:

Bad debt write off

I’m sorry to hear that your client has not paid you. Hopefully their financial situation is not as bad as rumoured and you’ll get paid in full eventually. However, if you don’t, there is a procedure you can follow to make sure you don’t end up paying tax on income you never receive. It’s called writing off a bad debt.

The first thing is to be specific about what is owed and the date when it should have been paid. Hopefully your sales invoice will have specified your payment terms. You can’t just use an estimate of how much you’ll be underpaid by clients in general over the course of a year – to get tax relief bad debts have to be specific.

You must make a reasonable effort to collect the money owed by your client. What is reasonable depends on how much is owed.

For small amounts, a few phone calls, followed up with a letter or email would be enough.

But, for a larger amount, you should use more official channels such as a debt collection agency, solicitor or the services of the small claims court.

Remember to always keep a written record of the efforts you’ve made to collect the money owed to your business.

As you’ve heard on the grapevine that your client might be in financial trouble, you should keep an eye on the local press, and other information sources, to see if a liquidator is called in. Should this happen, you should contact the liquidator as soon as possible to make sure your debt is known to them. Once the liquidator has determined how much money, if any, is available to pay creditors (such as your business), you will be told how much of the total amount you’re owed that you’ll receive. The rest will be your bad debt.

At your year end, 30th September, you may already know that your client has gone into liquidation and that you won’t get any, or only a percentage, of the money you’re owed. In this case, you can treat the amount you won’t get paid as a bad debt in your accounts.


Accounting for bad debts

In your accounts, you’ll record the bad debt as an expense in your profit and loss account, posting the other side to your balance sheet against Trade Debtors (also known as Accounts Receivable). This means that your unpaid sales invoice isn’t included on your balance sheet as money owed to you at year-end.

You leave the amount of your unpaid sales invoice in with your sales income.

Effectively, the sales income and the bad debt expense offset each other, and you have no tax to pay on the sales income – but the income and expense are allocated to separate categories on the profit and loss account.

Remember, aside from bad debt adjustments you also need to consider other year end accounting adjustments.


What if the bad debt position is unknown at year-end?

It may be the case that your client has still not paid you in full by 30th September, but they’re still trading. In this situation, if you have evidence to firmly believe you won’t receive any more money from your client, and as long as you’ve made your reasonable effort to chase the debt, you can still record the amount owed as a bad debt in your expenses, as above.

However as your year end is less than three months after you issued the sales invoice to your client, it’s likely that you won’t really know for certain if you’re going to be paid or not. In this circumstance, you shouldn’t record the bad debt expense immediately.

Your accounts to 30th September aren’t normally due for filing until the following 30th June. This gives you time to continue monitoring the client to see if they go into liquidation before your accounts are filed. If they do, you can update your accounts to include the bad debt expense.

Even if you have to file this year’s accounts without getting relief for your bad debt, you could still record the bad debt as an expense in the following year, if you still haven’t been paid.


Reversing a bad debt write off

Occasionally you may write off a bad debt but actually end up receiving some or all of the owed money further down the line. As you will already have written off the debt in your accounts, you’ll need to record the money they pay you as new sales income for the year in which they pay you.

It’s worth getting in the habit of reviewing what clients owe to you on a regular basis, say once a month, and establishing a routine for chasing late payers. That way you’ll already have made your reasonable effort to chase debts and will have your list of potential write-offs ready at year-end.

The advice in this article is about tax relief on bad debts – when it comes to VAT there are specific rules about bad debt relief which HMRC discuss here.