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.
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.