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Legal Opinion – Some Advice for the Chief Accountant, or How to Write Off Bad Receivables without the Risk of Additional Charges
The next round of strengthening of control over the implementation of economic activities by the regulatory authorities, including the one during tax audits, and the possible additional assessment of tax liabilities and penalties makes is necessary to introduce careful changes to the company’s balance sheet and take into account possible tax consequences based on the results of filing annual financial statements.
The issue of making entries in the balance sheet of the enterprise with the enterprise’s receivables deserves special attention, since the accumulation or write-off of debts in current assets can significantly affect the tax liabilities of the enterprise. Let us consider the issue of writing off bad accounts receivable.
Clause 14.1.11. of Art. 14 of the Tax Code of Ukraine (hereinafter referred to as the TC of Ukraine) stipulates that a bad debt is a debt falling under one of the following characteristics:
- debt on obligations for which the limitation period has expired;
- overdue debt of a deceased individual; overdue debt of persons who have been declared missing, declared dead;
- a person’s debt overdue for more than 180 days, the amount of the aggregate claims of a creditor for which does not exceed the amount of the creditor’s undisputed claims for initiating bankruptcy proceedings, and for individuals – the debt not exceeding 25% of the minimum wage;
- asset in the form of corporate rights of non-debt securities, the issuer of which was declared bankrupt or terminated as a legal entity in connection with its liquidation;
- overdue debt of an individual or legal entity that has not been repaid due to the insufficiency of the property of the specified person or entity;
- debt the collection of which has become impossible due to force majeure;
- debts of business entities declared bankrupt or terminated as legal entities in connection with their liquidation; other debts.
Among the listed criteria for recognizing a debt as uncollectible, one of the most commonly used is the expiration of the limitation period for the obligations from which the receivable arose.
Procedure for Writing Off Bad Receivables
- Allocation of the amount of receivables to the reserve for doubtful debts.
According to clause 4 of the National Regulation (Standard) of Accounting 10 “Accounts Receivable”, bad accounts receivable are the current accounts receivable in respect of which there is confidence that they will not be returned by the debtor or for which the limitation period has expired.
Doubtful debt is a current receivable in relation to which there is uncertainty about its repayment by the debtor.
In order to create a reserve of doubtful debts, the following documents are used to substantiate the recognition of the doubtfulness, and in the future, the irrecoverability of the debt:
- Order on the creation of a reserve of doubtful debts by the head of the enterprise;
- Carrying out an inventory of accounts receivable (if it is necessary to make significant changes to the “Current Assets” section of the balance sheet of the enterprise) by the order of the head of the enterprise.
The results of the inventory are set out in the Act of the Inventory Commission and approved by the order of the head. Next, an order to create a reserve of doubtful debts is approved;
- Professional judgment of a specialist (accountant, lawyer) or a hired specialist is executed in the form of a written opinion.
As a result of the application of these methods, a reserve of doubtful debts is formed in accordance with the requirements of National Accounting Regulations (Standards) (hereinafter referred to as NAR(S)) or International Financial Reporting Standards (hereinafter referred to as IFRS).
Such a reserve must be formed before the expiration of the statute of limitations to collect debt under the obligation of the counterparty of the enterprise.
The formation of a reserve of doubtful debts from the point of view of regulatory authorities is mandatory, which is confirmed by the position set out in the Letter of the Ministry of Finance of Ukraine dated October 15, 2010 No. 31-34020-20-16/28057:
“Failure to create a reserve of doubtful debts during the period when the receivables were still doubtful can be considered a mistake. After all, the creation of a reserve of doubtful debts in accordance with the accounting rules (based on the requirements of NAR(S) 10) is mandatory.”
Consequently, if an enterprise creates a reserve for doubtful debts for the debt that is already non-recoverable, this may unreasonably, from the point of view of regulatory authorities, affect the financial result of the enterprise as an object of taxation. This can be used in the future as a basis for additional accrual of income tax and the application of penalties in relation to the company. Accordingly, we advise against such an approach.
- After the expiration of the limitation period, as a frequent basis for writing off bad accounts receivable, authorized persons of the enterprise make a decision to write off bad accounts receivable.
Depending on the requirements of the internal regulations of the enterprise, including the order on accounting policy, authorized persons may include:
- head of the enterprise;
- company’s accountant or other person in charge of accounting;
- commission on non-production costs.
In other words, the enterprise, depending on the amounts of receivables to be written off, and on the basis of the requirements set out in the order on accounting policy, has the right to assign specific persons responsible for monitoring the formation of debts and the expediency of assigning doubtful debts to the reserve and/or writing off such debts.
- Application of professional judgment of a specialist and a written opinion or the results of a comprehensive analysis at the request of a legal entity.
When writing off bad accounts receivable in accordance with the explanations of the Ministry of Finance (see the Letter of December 09, 2003 No. 31-04200-30-5/7021), it is assumed that the classification of receivables as doubtful depends on the circumstances and is supported by professional judgment.
At the same time, the compliance of the debt with the condition of the expiration of the limitation period for recognizing it as irrecoverable according to the Tax Code of Ukraine is not the only reason for this, since, according to the explanations of the Ministry of Finance (see the Letter of December 09, 2003 No. 31-04200-30-5/7021), the classification of receivables as doubtful depends on the circumstances and is confirmed by a professional judgment.
The notion of a professional judgment is more common for International Financial Accounting Standards. Ukrainian accounting standards do not provide for this flexibility.
Nevertheless, there is a well-established practice of using written opinions during inspections by supervisory authorities, namely, an audit or legal opinion requested by an order from a legal entity as a basis for further write-off. Such a written opinion regarding the judgment of a specialist of a legal entity enjoys greater independence from the point of view of the regulatory authorities, since it requires a separate confirmation of the qualifications of the involved specialist (company).
Audit or legal written opinions are formed on the basis of a comprehensive analysis on a number of issues that are submitted by the enterprise, and, according to the provided documents, which indicate the contractual relations of counterparties, the periods of occurrence of mutual obligations, an analysis of the fulfillment and/or non-fulfillment of such is carried out; the pre-trial settlement of debt that has arisen and the financial condition of the counterparty are studied, and appropriate recommendations for further litigation or (if there are grounds) for classifying and further writing off receivables as uncollectible are provided.
A common sign of a counterparty’s insolvency to meet its obligations is persistent financial insolvency, as evidenced by the presence of external creditors, court decisions on outstanding financial obligations, tax liens and/or bankruptcy proceedings. It should also be borne in mind that the fact that the enterprise passes the limitation period for going to court in the capacity of the creditor, as well as the application of the limitation period on the part of the debtor also indicate the grounds for classifying the debt as irrecoverable.
In the event that bad accounts receivable are written off solely on the basis of the professional judgment of a specialist (company accountant) during inspections by the controlling bodies, the authorized persons of the latter may require additional explanations from the person responsible for maintaining the accounting records regarding the grounds for recognizing the accounts receivable as hopeless. In such cases, it is recommended to issue a written statement in advance, and also, if there is a separate requirement in the accounting policy of the enterprise, to issue such a statement (of an accountant, chief accountant) in the form of a report addressed to the head.
Applying the Materiality Threshold When Writing Off Receivables
Additionally, it is necessary to pay attention to the use of materiality in the accounting of an enterprise, since, in terms of writing off accounts receivable, the Methodological Recommendations of the Ministry of Finance of Ukraine dated July 29, 2003 No. 04230-04108 on the Application of Materiality in Accounting provide that the essence of certain business transactions and accounting items provides for the need for the enterprise to disclose information on transactions for certain types of assets, in particular, accounts receivable, deferred tax assets and equity; specifically, unallocated profit – 5% of the total assets and equity capital of the enterprise, respectively.
This means that, in the case of correcting errors made in the company’s reporting and the presence (achievement) of at least one of the indicators of the materiality threshold as a result of such corrections, it is advisable to disclose (publish) information on correcting errors in accordance with the provisions of the Letter of the Ministry of Finance of Ukraine of September 22, 2003 No. 31-04220-20-10/2515.
Thus, based on the above, writing off bad receivables should be carried out as follows:
- The date of origin of the counterparty’s receivables for contractual obligations to a legal entity in order to determine the end of the statute of limitations is established;
- Based on the accounting policy of the enterprise, the responsible person decides to create a reserve of doubtful debts (drawn up by an order), or an order is approved to conduct an inventory of accounts receivable, depending on the amounts to be written off;
- The person in charge of accounting forms a reserve of doubtful debts by adjusting it to NAR(S) and reflecting it in the balance sheet of the enterprise on the basis of an order to create a reserve of doubtful debts;
- To substantiate and confirm the grounds for the legitimacy of creating a reserve of doubtful debts and writing off bad debts (especially for large amounts of debt for individual counterparties), it is necessary to draw up a written opinion – the professional judgment of a specialist (accountant, auditor, lawyer);
- Another option is to carry out a comprehensive analysis of the status of settlements for accounts receivable and payable at the request of a legal entity to provide the regulatory authorities with the justification for significant changes in the company’s balance sheet during tax audits;
- The order on recognizing the amount of receivables assigned to the reserve for doubtful debts as hopeless and making a decision to write off is executed.
We draw your attention to the fact that the formation of a reserve of doubtful debts and/or writing off bad accounts receivable in the preparation of annual financial statements may affect the financial result of taxation on income tax.
Clause 139.2 of Art. 139 of the TC of Ukraine stipulates that, in connection with the formation of a reserve for doubtful debts or a reserve for expected credit losses (depreciation of assets), the financial result:
- shall be increased by the amount of:
- expenses for the formation of a reserve for doubtful debts or a reserve for expected credit losses (depreciation of assets) in accordance with NAR(S) or IFRS;
- expenses from writing off accounts receivable in excess of the amount of the reserve for doubtful debts or in excess of the reserve for expected credit losses (depreciation of assets).
- shall be decreased by the amount of:
- adjustment (decrease) of the reserve for doubtful debts or the reserve for expected credit losses (depreciation of assets), which increased the financial result before tax in accordance with the NAR(S) or IFRS;
- written off accounts receivable (including at the expense of the created reserve for doubtful debts or the reserve for expected credit losses (depreciation of assets), which corresponds to the criteria specified in subclause 14.1.11 of clause 14.1 of Art. 14 of the TC of Ukraine.
Conclusively, the write-off of bad accounts receivable of the counterparty will entail a decrease in the financial result to taxation with income tax for the legal entity.
It is worth noting that if the counterparty is an affiliate person, the business owner must take into account that for a legal entity, writing off accounts receivable by it entails a decrease in accounts payable for such a counterparty (affiliate person) and, accordingly, an increase in the financial result through income taxation. However, the legislation of Ukraine does not stipulate the obligation for a legal entity to reduce the amount of accounts payable in the event that they are written off (classified as uncollectible) by another legal entity.
Lawyer of the “PRIME” Law Firm Yekateryna Malamaniuk