As an organization, it is almost a norm to incur bad debts in the process of running a business. Bad debt can be defined as an expense arising from the company’s account receivables becoming unretrievable/ uncollectible. This is an operational and financial risk associated with the daily running of a business and the account receivables should be assessed for impairment on a forward-looking basis and reported in the financial statements for each year at the financial year-end in line with International Reporting Standards (IFRS) 9 which is on “Financial Instruments”. A lot of reasons can be factored into account receivables becoming uncollectible thus becoming bad such as:
- The company with the account receivable is unable to collect the debt due to technical reasons;
- The debtor fails to pay the debt within a specified timeline;
- When the debtor shows an unwillingness to pay the debt amount;
- When the debtor is incapable of paying the debt due to bankruptcy.
Classification of bad debts
Provisions are usually made in the company’s account for bad debts/impairments as bad debts are expensed in the company’s accounts. Bad debts are classified into three (3) stages, and this has to do with the amount of time during which the debt has not been recovered:
- Stage 1: the account receivable still looks collectible but would be recognized as there is a possibility of a loss of credit irrespective of this risk being minimal. This is usually within the first 30 days of credit.
- Stage 2: at this stage, there is a significant increase in the credit risk since the time of recognition (stage 1) of the account receivable. This is usually above 30 days of non-collection of the account receivable.
- Stage 3: at this stage, there is a non-performance by the debtor in respect to payment of the account receivables and debt recovery has been attempted. This is usually when the non-collection of the account receivable exceeds 90 days.
Tax Treatment of Bad debts
Only bad debts in stage 3 are allowed for tax purposes when computing the Company Income Tax for any given period in line with the provisions of the S24 Company Income Tax Act (CITA) to ascertain assessable profit. Stages 1 and 2 are disallowed and added back to the profit/loss before interest and tax in line with the provisions of S27 CITA to ascertain assessable profit. For a debt to be classified as bad, it needs to meet the following requirements:
- A debt recovery agency has been employed to recover the debt to no avail;
- A Board resolution has been issued stating the debt has become bad;
- Evidence of bankruptcy by the debtor.
A sticking point on the argument between Organizations and the FIRS has been on the amount of time elapsed between when the account receivable was issued to the debtor and when the debt was classified to be in Stage 3. This stems from most organizations classifying their bad debt to be in stage 3 after it exceeds 90 days of the account receivable being uncollectible. FIRS officials have been strongly opinionated that 90 days is not sufficient time to have exhausted all means of debt recovery before concluding that the account receivable is uncollectible. Thus, on many occasions, the FIRS opts to accept debts that are up to 180 days old to be in Stage 3.
It is important to note that should any of the debt in stage 3 which had been allowed for tax purposes in previous years be recovered, it would be reported in the financial statement as an income. This income would be treated as taxable income at the rate of 30% in line with the CIT rate.