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Bad debts can be bad news for small business. Chris Ridd, managing director of small business accounting software provider Xero Australia, explains how you can deduct them from your tax – and how you can avoid them.

There’s nothing worse than not getting paid for your hard work. But while it is disappointing, there is some consolation for small business-owners: you can claim the bad debt as a tax deduction.

As you prepare this year’s tax return, comb through your debtor’s ledger to see which of your outstanding debts can be classified as bad debts and be deducted. Don’t delay, because you have to do this before June 30 if you want to qualify for a deduction.

While you’re at it, use tax time to think about your debt collection procedures can be improved to boost your cash flow.

Is the debt deductible?

You can’t just claim a deduction for any old debt. The Tax Office can ask for proof that what you are claiming for is in fact a bad debt.

The debt owed to you must have been included in your assessable income. In accruals accounting this means you counted the income when you issued the invoice rather than waiting until you received payment.

You also have to have made a reasonable attempt to recover the debt. For a debt of a couple of hundred dollars, this might just be a phone call or a letter, because it’s not worth spending any more time collecting such a small amount. But for a debt in the tens of thousands of dollars, say, you probably want to consider legal action before you declare the debt bad.

Finally, you have to formally write off the debt in your accounting records. Even if you only write off part of a debt, it is possible to claim a deduction for the written-off portion. Watch out for debts owed to you by related parties (such as a family member or business partner) because these aren’t deductible.

And there’s a bit more good news about bad debts. If you pay GST on an accruals basis (that is, paying GST when invoices are issued, not waiting until payment) then you can get a refund on the GST you paid.

Don’t lose track, find a better way to manage bad debt

Of course, it’s best to try to stop being hit by bad debts in the first place.

Once you’ve identified the bad debts you want to deduct and have written them off, start thinking about your debt collection procedures and what you can change.

Amanda Fisher of Sydney-based Connected Accountants says it’s easier than ever to keep track of your debtors using small business accounting software like Xero.

Because Xero is cloud-based, it can automatically reconcile your bank account, so you know every day exactly how much money is owed to you and by whom. You can start following up debtors once they become overdue.

There’s a saying that the squeaky wheel gets the grease – and nowhere is this truer than with debt collection. If you chase up organisations that owe you money on a consistent basis, you’re more likely to get paid.

But the longer you leave it, the less likely it is that you’ll be able to collect.

First, make a courtesy call to remind an overdue debtor that they owe you money, then follow up with a letter or email.

It’s all about cash flow

Managing your debtors isn’t just about getting paid, it’s also about when you get paid. The sooner you get paid, the better your cash flow, which is the lifeblood of any business.

So use your accounting software to look at average debtor days. This is a measure of how long on average it’s taking for your invoices to get paid. Obviously the lower average debtor days are the better – the sooner the money comes in the sooner you can start using it.

If your payment terms are, say, 30 days you should aim to keep your average debtor days below that level.

Some clever add-ons are available for Xero to take the hard work out of chasing debtors. These are low-cost solutions that send out automated invoice reminders and collections tracking to help save time and boost cash flow.

There are a couple of other things you can do as well.

Have a look at the terms on your invoices and consider reducing the payment terms, for instance from 30 days to 14 days.

Another tactic is to offer a small discount – say 5 percent – to customers who pay promptly. This relatively small cost can save you headaches in the long run.

Don’t delay. Clean up your debtors’ ledger and get the money rolling in!

The information contained in this article is general in nature and does not take into account your personal situation or you business’ circumstances. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from an accountant or other qualified professional.