End of financial year is fast approaching and for every small and medium business now is an ideal time to evaluate your unpaid invoices and bad debt. Most SMEs have likely encountered a bad debt in the past. Ever had a customer that hasn’t paid you for your goods and services? You may do the work, then invoice your client and set a due date, then you wait for payment, but nothing happens. These amounts should be written off.
Typically, a larger business gets their payments team to chase up any overdue invoices and then receives the payment. For small businesses, the owner may simply send a few emails or make a few phone calls and then payment is made.
But what happens when your client’s financial position makes it impossible for them to pay the debt they owe to you? Or what if you have the misfortune of dealing with a customer that takes every possible action to evade their amounts owed to you?
This is bad debt; one that you are unlikely to have repaid. So, what happens next? One option is to write off this bad debt, as it may provide your business with a tax deductable expense.
No matter what industry you work in, if you are self-employed or the head of a company, chances are you will have experienced trouble with timely invoice collection. The problem is by no means limited to Australia. A survey conducted by the Commercial Collection Agency Association in the USA found that – as time goes by – the likelihood of receiving payment in full greatly diminishes.
The findings showed that while most invoices are paid in full before the due date, the likelihood that they will be paid at all has already dropped by over 5% by time that due date rolls around. Thirty days later, this has dropped even further to only 89.9%, and ninety days after the due date, only 69.6% of invoices get paid. Needless to say, it’s only downhill from here; the findings show that two years after the due date, the likelihood of receiving payment for an outstanding invoice drops to only 9.3%.
This creates an invoice blackhole, and it is the cause of some major cash flow problems for businesses. This problem has existed for as long as invoicing has been a standard business practice.
Steps for Writing Off a Bad Debt
So how does a business go about writing off those unpaid invoices against their tax obligations? Well, first of all you need to wait. Maybe you know that you aren’t going to be paid by a client, and they have made it pretty clear that they know that too. However in order to classify the amount owing to you as a bad debt for tax purposes, the Australian Taxation Office says it must be 12 months overdue. Once the debt slips beyond this mark, the ATO will recognise the unlikelihood that it will be paid and will allow you to write it off.
However this income must have already been recorded as part of your assessable income either for that year’s tax assessment return or for any previous year. If this is the case, you may submit the updated information regarding the non-payment to the taxation office as part of your assessable income tax return. Be sure to submit all the necessary documentation before the end of the financial year to prevent a delay in the process.
Things to Remember
The Income Tax Assessment Act 1997, section 25-35 stipulates the following;
“You can deduct a debt (or part of a debt) that you write off as bad in the income year if:
(a) it was included in your assessable income for the income year or for an earlier income, or;
(b) it is in respect of money that you lent in the ordinary course of your business of lending money.”
Always bear this in mind when you are trying to write off any bad debts or unpaid invoices. We’ve compiled some tips to help you through the process:
- Remember to complete the process of writing off the unpaid invoice before the end of the financial year. This one might seem obvious, but it can be easily forgotten considering all of your accounting and tax obligations.
- You can only write off a debt which is bad to ensure a deduction is allowable, i.e. it needs to be a debt which is unlikely to be paid at all.
- All debts which are written off must be supported by documented paperwork.
- Any amounts that you write off are deducted from your bottom line profits, so be cautious about the process of writing off bad debts.
- If you report your income on an accrual basis, you may be eligible to claim a refund of the GST paid to the ATO on sales. Income from business activities will generally be returned on an accruals basis and will ordinarily be derived for tax purposes when a recoverable debt arises (i.e. when the invoice is raised).
- When an amount has been outstanding beyond 12 months, you can write it off and claim GST credits
Make sure you try all options for collecting your Accounts Receivable balance before deciding to write off a bad debt, as this will impact your profit. Importantly, bad debts must be written off during the year and not after the end of the financial year.
Reckon does not provide tax or legal advice. Information in this blog should not be relied upon as professional advice. For your individual circumstances you should consult with your own professional adviser, tax expert, or lawyer.