Introduction:
In the normal course of business operations, organizations often encounter bad debts, defined as expenses arising from irretrievable or uncollectible account receivables. Managing bad debts involves assessing their impairment on a forward-looking basis and reporting them in financial statements, adhering to International Financial Reporting Standards (IFRS) 9 on “Financial Instruments.” Various reasons contribute to account receivables turning bad, such as technical issues, delayed payments, debtor unwillingness, or debtor bankruptcy.
Classification of Bad Debts:
Provisions for bad debts/impairments are made in a company’s accounts, and bad debts are categorized into three stages based on the duration of non-recovery:
- Stage 1: Account receivable still deemed collectible, but credit loss is possible, typically within the first 30 days.
- Stage 2: Significant increase in credit risk observed, usually beyond 30 days of non-collection.
- Stage 3: Non-performance by the debtor, with attempts at debt recovery proving unsuccessful, generally exceeding 90 days.
Tax Treatment of Bad Debts:
For tax purposes in computing Company Income Tax, only bad debts in Stage 3 are allowed, as per Section 24 of the Company Income Tax Act (CITA), contributing to the assessment of assessable profit. Stages 1 and 2 are disallowed and added back to profit/loss before interest and tax under Section 27 of CITA to determine assessable profit.
To classify a debt as bad for tax purposes, it must meet specific criteria:
- Employment of a debt recovery agency without success.
- Issuance of a Board resolution declaring the debt as bad.
- Evidence of debtor bankruptcy.
Debates and FIRS Practices:
A key contention between organizations and the Federal Inland Revenue Service (FIRS) revolves around the time elapsed between issuing the account receivable and classifying the debt as Stage 3. While organizations often consider 90 days sufficient, the FIRS asserts that it may not be adequate to exhaust all debt recovery avenues. Consequently, the FIRS sometimes accepts debts up to 180 days old to be in Stage 3.
Recovery and Tax Implications:
Recovered debts previously allowed for tax purposes are reported as income in financial statements. This income is subject to taxation at the CIT rate of 30%.
Conclusion:
Understanding the management and tax implications of bad debts, particularly in alignment with FIRS practices, is crucial for organizations to navigate this aspect of financial operations effectively.
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