How to account for bad debts as a limited company

Bad debt relief allows a limited company to reduce its taxable profits where invoices are unlikely to be paid, helping contractors avoid paying Corporation Tax on income they may never actually receive.

What happens in the accounts if an invoice remains unpaid?

Most contractors running a limited company prepare accounts on an accruals basis. In simple terms, that means income is recognised when you raise the invoice, not when the client actually pays you.

Usually, it makes no difference, but occasionally it can become a problem.

A client may delay payment for months, an agency could dispute an invoice, or a business may even go under and end up in liquidation.

Meanwhile, the unpaid invoice is still sitting in your company’s accounts as income, even though the money may never arrive in the company’s bank account.

In this guide, Michael McCullion, MD of Bright Ideas Accountancy, explains that if you don’t do anything, your company can end up paying Corporation Tax on profits it never genuinely received.

That is where bad debt relief and doubtful debt provisions come in.

Although your accountant will typically handle the technical entries, directors should understand how debt provisions are made, particularly if a large invoice has been outstanding for a while or if your year-end is approaching.

Why unpaid invoices matter in company accounts

An unpaid invoice normally sits in trade debtors (also called receivables) on the balance sheet. Until anything changes, the outstanding sum still counts as income in your accounts.

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That can create an artificial profit figure.

If your company invoices £10,000 near the year-end but never actually receives the money, your accounts may still show the income unless a write-off or provision is made.

Corporation Tax is then calculated on profits which do not really exist in real cash terms.

This is particularly relevant for contractors because a single overdue invoice can represent a large proportion of yearly income.

An adjustment for bad debts will make the accounts reflect the real situation and prevent the company’s profits from being overstated.

When can a limited company claim bad debt relief?

Relief can be provided when a debt has genuinely become ‘bad’, provided there is evidence to support this.

Specifically:

• the debt must relate to normal trading income
• you must have made reasonable attempts to recover the money
• there is a reasonable basis for believing the amount may not be recoverable
• the write-off or provision must appear in the accounts

For a typical company, ‘evidence’ doesn’t necessarily mean taking a non-payer to small claims court. A paper trail of emails, reminders, and failed payment pledges from a client will usually suffice.

If a client or agency has gone into administration or stopped trading, the position is even clearer-cut.

You can read more in HMRC’s BIM42700, which has specific guidance on bad and doubtful debts.

Is it a slow payer or genuinely bad debt?

There is a distinction here.

Some agencies and clients are simply slow payers. You may have to wait 60 or even 90 days to receive payment, especially on larger projects.

Although this is frustrating, it does not automatically mean that the debt is bad.

Bad debt relief is normally relevant only when there is evidence that payment is unlikely, uncertain, or only partially recoverable.

How are bad debts treated in your accounts?

In practice, there are two slightly different situations.

Writing off a bad debt completely

Where the invoice is considered to be irrecoverable, the debt is removed from trade debtors and recognised as an expense in the profit and loss account.

The accounting entry is typically:

• Debit: Bad debt expense
• Credit: Trade debtors

That reduces the company’s profits and, therefore, reduces Corporation Tax.

Making a doubtful debt provision

What if a debt appears unlikely to be paid, and there is no certainty about how it will be recovered?

For example, only part of the invoice may be disputed, or the liquidator may expect creditors to recover only a small percentage of their claim eventually.

In cases like this, your accountant may create a specific provision against the invoice rather than write off the entire balance immediately.

The important word here is specific. The provision needs to be properly supported against a single debt, not a general provision such as “5% of debtors may not pay”.

What if the client goes into liquidation?

If you receive notice from a liquidator or administrator that confirms insolvency proceedings are underway, this is strong evidence that a debt is impaired or irrecoverable.

Make sure you keep copies of:

• liquidator correspondence
• formal notices
• emails confirming insolvency
• creditor communications

You may need to produce this documentation in case HMRC ever queries the deduction.

What about VAT bad debt relief?

If your company is VAT-registered, you may also be able to reclaim the VAT already paid to HMRC on invoices which were never paid.

Normally, the main conditions are:

• at least six months have passed since the invoice date or payment due date
• the debt has been written off in the accounts
• the VAT has already been accounted for and paid to HMRC
• the debt has not been sold or factored

The reclaim is usually made through the VAT return by adjusting the input VAT figure.

For larger unpaid invoices, the VAT relief can be significant.

Talk to your accountant

The timing of a bad debt provision can sometimes make a lot of difference.

For example, if there are clear signs that a debt has become bad before the company’s year-end, it is usually better for the adjustment to appear in that accounting period rather than waiting until the next year.

This is why it’s essential to discuss any potential bad debts with your accountant.

Your accountant will usually look at how likely the debt is to be recovered, what evidence exists that payment may not happen, whether a provision or full write-off makes more sense, which year the adjustment should fall into, and whether you can also reclaim the VAT.