Is bad debt provision tax deductible?

Companies use various strategies to increase their sales. Usually, these strategies involve marketing and sale tactics that can help grow revenues. In some cases, these may also include providing discounts to customers. One such technique most companies benefit from is providing credit terms to customers. This way, companies can offer their products and services to customers that can’t pay for them promptly.

Credit sales involve companies allowing customers to buy products and services. However, these sales do not require payment from them. Instead, the company lets the customer pay at a later date. This date or period falls under the credit term offered to the customer. In most cases, companies allow a few days so the customer can arrange the payment. However, this term may differ from one company to another and between industries.

Credit sales can be highly crucial in growing revenues. It provides companies access to a higher range of customers, specifically those who prefer to pay later. However, these sales can also result in bad debts. In some cases, these bad debts can be a tax-deductible expense. Nonetheless, the tax treatment of this expense depends on the jurisdiction and its tax policies.

What is Bad Debt?

Bad debt is an expense that companies charge in the income statement. This expense relates to the accounts receivable that companies accumulate from credit sales. In most instances, these bad debts result in a permanent expense to the company. However, it may also be temporary. Therefore, companies can still recover those debts.

Bad debts result from the credit extended to customers from a previous transaction. Usually, the later the due date is, the higher the chances of bad debts are. As customers delay payments, companies may become doubtful of those payments. On top of that, companies may also consider any debts that pass the due date to be bad debt.

Bad debt is an expense for companies. Most companies that offer credit sales also charge bad debts in their income statement. On top of that, these bad debts also decrease the accounts receivable balance in the balance sheet. Therefore, it impacts both the financial statements at the same time. Usually, the industry in which a company operates also dictates its bad debt expenses.

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Another name used to describe bad debts is uncollectible accounts expense. It represents the monetary amount owed by a debtor that the company deems unlikely to be repaid. In most cases, companies do not pursue these debts unless they are material. Similarly, customers may also have a genuine reason not to make payments at the agreed time. For example, they may not have assets to repay the company or become insolvent.

Bad debts are expenses in the income statement which represent the amount not repaid by customers. For companies allowing credit sales, it is common to have these expenses. Bad debts may occur due to several reasons. In most cases, the company or customer may not control the inability to repay. Regardless of that, companies record these bad debts in their financial statements.

What is the provision for bad debts?

When companies encounter bad debts, they must create a bad debt expense in the financial statements. This expense is for the amount that the company is certain is unrecoverable. Usually, companies must perform different reviews to ensure bad debts exist. In most cases, it will involve analyzing the customers separately and performing an ageing analysis.

In some cases, however, companies may also estimate the percentage of bad debts that will occur in the future. This estimation falls under the provision for bad debts. Usually, it includes the total doubtful debts that a company estimates its customers to create. Companies use their historical performances to measure the probability of these doubtful debts.

The provision for bad debts is not similar to the actual bad debts. This provision falls under a contra asset account that reduces the accounts receivable balance in the balance sheet. Similarly, it also creates an expense in the income statement. Unlike bad debts, doubtful debts do not impact the accounts receivable balance. Instead, it uses a contra asset account, which creates a temporary reduction in it.

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Every year, companies estimate the bad debt provision in the accounts. Once they do so, they must compare it to the existing balance in the bad debt provision account. If this balance is lower than the estimated amount, the company must recognize an expense for the excess value. In contrast, it must record an income if the bad debt provision account balance is above the calculated provision.

Overall, provision for bad debt is an estimated amount for any debts that the company deems doubtful for recovery. This amount depends on a company’s calculation based on historical results. However, it differs from actual bad debts in several ways. However, the tax treatment of bad debt provision may be an issue since it does not represent an actual expense.

Is bad debt provision tax deductible?

The treatment of bad debt provision may differ from one jurisdiction to another. Generally, bad debts are an allowable expense if the company proves recovering probability is low. However, this treatment may also differ based on the tax laws and policies which a company follows. Bad debt provisions, however, are a different issue due to how they work.

In the US, the IRS handles all tax matters. Under IRS’s requirements, companies have two types of bad debts. The first is “a loss from the worthlessness of a debt that was either created or acquired in a trade or business or closely related to trade or business when it became partly to totally worthless”. In essence, any debt relating to a company’s primary activities falls under a business debt.

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The IRS allows companies to deduct their bad debts, in full or in part, from gross income. Consequently, they can reach a taxable income, which forms the base for the tax they must pay. Therefore, the IRS allows companies to deduct their business bad debts from their income. In some cases, it may also include the bad debt provision that companies create for doubtful debts.

Any bad debts that do not classify under the business category will fall under nonbusiness bad debts. For companies to subtract these from taxable income, they must establish they are totally worthless. The IRS does not allow companies to deduct any partially worthless debts under the nonbusiness category. Therefore, determining the worthlessness of these debts is crucial.

If a bad debt provision falls under the nonbusiness category, companies cannot deduct these from their taxable incomes. Since most of these provisions are not fully worthless, companies cannot establish them for the deduction. As mentioned, bad debt provisions only represent a company’s estimation of any doubtful debts for the future. Therefore, the bad debt provision is not tax-deductible if it is nonbusiness.

Overall, whether a bad debt provision is tax-deductible depends on several factors. The most crucial of these is the jurisdiction under which a company operates. The tax laws will determine whether companies can charge these as a tax-deductible expense. In most cases, these may not be allowed taxable deductions since bad debt provisions are estimates.

Conclusion

Bad debt is an expense that results from a customer’s inability to pay their debt. A bad debt provision, in contrast, is an estimate of doubtful debts that may become worse in the future. For most companies, the jurisdiction in which they operate will determine whether these provisions are tax-deductible. However, since they are an estimate, it is unlikely to reduce the taxable income.