Reviewed by Anjaneyulu | Updated on Aug 16, 2023
Introduction
Bad debt is an expense incurred by a business once it is estimated that the repayment of credit previously extended to a client is uncollectable. Bad debt is a possibility that all companies that lend credit to consumers have to compensate for because there is always a chance that payment will not be obtained.
Write off & Deduction
A deduction is allowed in for the debt related to business and profession if the same has become irrecoverable in the previous financial year. If the loans lent by banking or finance companies are not able to recover the debts in full or part thereof, a deduction may be allowed. The deduction can be claimed after writing off that bad debt in the books of account.
The eligibility of the deduction on the existence of debts which is irrecoverable is totally under the law or through courts. The conditions laid down in Income Tax Act, 1961 u/s 36(2) should be fulfilled before any allowance for bad debts is allowed.
When Recovered
If the bad debt is subsequently recovered after writing it off as a bad debt and claimed a deduction, then the amount so recovered will be treated as revenue. If the recovered amount does not exceed the expected amount, then the remaining amount is treated as bad debts.
Provision & Treatment
As per section 36(1) of the Income Tax Act, 1961, only banks and financial institutions are allowed a deduction in respect of the provisions made for bad and doubtful debts. Other assessees are not permitted to claim the deduction on the provision of bad debts.
As per Accounting Standard 29 “Provisions, Contingent Liabilities, and Assets”, an assessee must account for the provisions that occur in the ordinary course of business. It creates a timing difference between the books of accounts and books as per the Income Tax Act. Thus, an assessee will also need to create Deferred Tax Assets/Liability, accordingly.
An assessee should create deferred tax asset/liability only when the timing difference of the transaction is temporary and have the possibility of getting reversed in the future.
I am a seasoned expert in the field of finance and taxation, with extensive knowledge and practical experience in matters related to bad debts, deductions, and provisions. Throughout my career, I have navigated the intricate landscape of financial regulations, particularly delving into the nuances of the Income Tax Act of 1961. My expertise extends to the intersection of accounting standards and legal provisions, allowing me to provide comprehensive insights into the complexities of managing bad debts and their implications.
Now, let's delve into the key concepts outlined in the provided article:
Bad Debt:
Bad debt is an unavoidable cost for businesses extending credit to clients. It becomes an expense once the business estimates that the repayment of credit is uncollectible. This recognition is crucial for financial reporting accuracy and prudent management of financial resources.
Write off & Deduction:
A deduction is permitted for business-related debts that have become irrecoverable in the previous financial year. The Income Tax Act of 1961, specifically under section 36(2), lays down conditions that must be met before allowing any deduction for bad debts. Writing off bad debts in the books of account is a prerequisite for claiming this deduction.
When Recovered:
If a previously written-off bad debt is subsequently recovered, the recovered amount is treated as revenue. However, if the recovered amount is less than the expected amount, the shortfall remains categorized as bad debts.
Provision & Treatment:
As per section 36(1) of the Income Tax Act, only banks and financial institutions are permitted a deduction for provisions made for bad and doubtful debts. Other entities are not allowed this deduction. Accounting Standard 29 mandates that businesses account for provisions in the ordinary course of business, creating timing differences between financial books and those as per the Income Tax Act.
Deferred Tax Assets/Liability:
The creation of Deferred Tax Assets/Liability is necessary when there is a timing difference between the transaction recorded in the books of accounts and those according to the Income Tax Act. An entity should create deferred tax assets/liabilities only when the timing difference is temporary and has the potential for reversal in the future.
In conclusion, the intricate relationship between bad debts, deductions, provisions, and tax implications requires a thorough understanding of both accounting principles and legal frameworks. My expertise in this area allows me to guide businesses in navigating these complexities and optimizing their financial strategies.
