Bad Debt

Definition

Bad debt is the portion of accounts receivable that a business concludes is uncollectible, the customer is unable or unwilling to pay, and further collection efforts are unlikely to succeed. When receivables are classified as bad debt, they are written off from the balance sheet (reducing the AR asset) and recognised as an expense (bad debt expense) in the profit and loss statement. This directly impacts profitability and reported earnings.

In India, bad debt treatment has specific tax and accounting implications. Under Section 36(1)(vii) of the Income Tax Act, a bad debt can be claimed as a deduction only if it was previously recognised as income and has been written off in the books of accounts. The Supreme Court ruling in TRF Ltd vs CIT (2010) established that it is not necessary for the assessee to prove that the debt has become irrecoverable, writing it off in the books is sufficient. For GST purposes, if output tax was already paid on the original invoice, Section 34 of the CGST Act allows issuance of a credit note to adjust the tax liability, subject to conditions and time limits.

Under Ind AS 109, Indian companies are required to follow the Expected Credit Loss (ECL) model for provisioning, which requires estimating potential bad debts based on historical loss rates, current conditions, and forward-looking information, rather than waiting for debts to actually default. This prospective approach means companies must continuously assess their receivables portfolio and maintain adequate provisions. For Indian MSMEs and SMEs not under Ind AS, the provisioning follows the general prudence principle under existing Indian Accounting Standards.

Key Points

• Bad debt is written off when receivables are deemed uncollectible, reducing assets and increasing expenses
• Tax deduction allowed under Section 36(1)(vii) of the Income Tax Act once written off in books (TRF Ltd vs CIT ruling)
• GST credit notes under Section 34 of CGST Act can adjust output tax liability on bad debts, subject to time limits
• Ind AS 109 requires the Expected Credit Loss (ECL) model: provision for losses before they actually occur
• Bad debt ratio (bad debts / total credit sales) should ideally be below 1-2% for healthy Indian businesses
• Aging analysis is the primary tool for identifying receivables at risk of becoming bad debts
• Regular credit assessment and structured collections processes are the best preventive measures