What is Bad Debt?

Bad debt is an amount owed to a business that is unlikely to be collected. When a customer cannot or will not pay, the debt becomes irrecoverable and must be written off in the accounts. Understanding how to recognise and account for bad debts is essential for accurate financial management and compliance with UK accounting standards.

When Does a Debt Become Bad?

A debt is generally considered bad when there is clear evidence that recovery is unlikely. Common indicators include:

• The customer has entered insolvency or administration
• Repeated collection attempts over an extended period have failed
• The customer has ceased trading without settling the balance
• A court judgment has been obtained but cannot be enforced
• The debt is statute-barred (typically six years under the Limitation Act 1980)
• The cost of pursuing the debt exceeds the amount owed

Writing Off a Bad Debt

When a debt is confirmed as irrecoverable, it is written off by removing it from accounts receivable and recognising a loss in the income statement.

Journal Entry for a Bad Debt Write-Off

This removes the receivable from the balance sheet and charges the loss to the income statement .

For more on how these entries are processed, see the guide to journal entries .

Allowance for Doubtful Debts

Rather than waiting until a debt is confirmed as irrecoverable, prudent accounting requires businesses to estimate likely losses and create an allowance for doubtful debts (also called a provision for bad debts).

How to Estimate the Allowance

There are two common methods:

The ageing method is more accurate because it reflects the increasing risk of non-payment as debts age.

Journal Entry to Create the Allowance

Adjusting the Allowance

At each reporting date, the allowance is reviewed and adjusted:

• If the estimated bad debts increase, an additional charge is made to the income statement
• If the estimated bad debts decrease, the excess allowance is reversed as income

Bad Debt and the Balance Sheet

Accounts receivable are shown net of the allowance for doubtful debts:

This presentation gives a more realistic view of the cash the business expects to collect.

Bad Debt and the Income Statement

The income statement shows the bad debt expense for the period:

UK Tax Treatment of Bad Debts

Corporation Tax Relief

Under HMRC rules, a business can claim a tax deduction for bad debts if:

• The debt was included in turnover (i.e., the income was recognised for tax purposes)
• The debt is genuinely irrecoverable — there must be evidence of impairment
• A specific provision has been made (general provisions are not tax-deductible)

VAT Bad Debt Relief

If a business has accounted for output VAT on a sale that subsequently becomes a bad debt, it can reclaim the VAT from HMRC provided:

• The debt is at least six months old from the date of supply or due date (whichever is later)
• The debt has been written off in the accounts
• The VAT was originally paid to HMRC
• The original supply was for a consideration in money

The VAT bad debt relief claim is made on the VAT return by adjusting Box 4.

Record-Keeping

HMRC requires businesses claiming bad debt relief to maintain records showing:

• The amount of the debt and the VAT element
• The date of supply and date of payment due
• Evidence that the debt has been written off
• The VAT period in which relief is claimed

Bad Debt Recovery

If a debt that was previously written off is subsequently paid (in whole or in part), the recovery must be recorded:

If VAT bad debt relief was claimed, the recovered VAT must be repaid to HMRC on the next VAT return.

Preventing Bad Debts

Minimising bad debts through effective credit control is a key objective of financial management . Strategies include:

Credit Assessment

• Run credit checks on new customers before offering credit terms
• Set appropriate credit limits based on the customer’s financial strength
• Request trade references and review publicly filed accounts at Companies House

Invoicing and Collection

• Issue invoices promptly and ensure they contain all required information
• Set clear payment terms and communicate them before the first sale
• Send payment reminders on or before the due date
• Follow up overdue debts systematically, escalating from reminder to formal demand

Payment Methods

• Encourage direct debit for recurring payments
• Request payment upfront or pro-forma for high-risk customers
• Offer early payment discounts to incentivise prompt settlement

Legal Remedies

• Charge statutory interest on late payments under the Late Payment of Commercial Debts (Interest) Act 1998
• Use the small claims court for debts up to £10,000
• Consider debt factoring or invoice insurance to transfer credit risk

FRS 102 Requirements

Under FRS 102 (the UK GAAP standard for small and medium-sized entities), bad debts are addressed in Section 11 (Basic Financial Instruments):

• Trade debtors are measured at the undiscounted amount of cash expected to be received
• At each reporting date, the entity must assess whether there is objective evidence of impairment
• If impairment exists, the carrying amount is reduced to the present value of estimated future cash flows, with the loss recognised in profit or loss
• Previously recognised impairment losses are reversed if circumstances improve, but the carrying amount must not exceed what it would have been without the impairment

Key Ratios