23 Nov So When Should I Write-off A Bad Debt?
When the costs associated with collecting that debt, outweigh the benefit of collection – the point of diminishing (or no) returns.
While this may seem like a logical point, many people do not fully consider the true total costs of holding on to long-outstanding debts, commonly referred to as the sunk-cost fallacy.
The sunk-cost fallacy states that when making a decision people lend more weight to the costs they’ve already incurred or effort already exerted in rendering a service, rather than focusing on the costs, time and effort to still to come.
Not wanting to see past efforts, care or energy go to waste, they put their pruning shears away and let projects (or patient debtors) grow indefinitely ploughing more time and energy into aging assets instead of focusing on converting new high yielding opportunities.
So what are some of the areas that need to be considered in making the decision regarding the point of no return?
Taxation (everyone’s first thought) – the financial savings associated with the Income Tax deduction and Value Added Tax (“VAT”) output adjustment on the face value of the debt (where applicable*) provide a positive cash flow effect for your practice on completion of the various taxation returns.
* We recommend always contacting a qualified experience registered tax practioner before applying tax legislation to your circumstances
Lost time – the more time you and your team, spend on low yield (quality) debt recovery, the less time you have to spend on the things that can add much more value to your practice and personal life – opportunity cost of lost time;
High yield debtors age when focus is lost and run the risk of also going bad – any time spent on aged (low-yield) debtors increases the risk that high ROI and high-yield debtors diminish in value. This will cost your practice further due to lack of cash conversion – the effect of compounding is significant here; and
Legal costs of debt collection – legislation in South Africa requires strict compliance, where legal action is used as a method to collect specific debtors, certain costs cannot be avoided, irrespective of if any cash is in fact received – further net cash outflow with no gains to the practice – legal collection needs to be focused for it to be effective and not diminish business value.
So while there is unfortunately no rule-of-thumb timeframe, for when a debt should be written off from date of service, the answer to the question “So when should I write off a bad debt?” is Regularly.
Regular review and well-considered write-offs ensures a cadence of focus on
conversion of high-yielding assets, improved returns on assets, allows your practice to take advantage of the tax benefits associated with write-offs and keeps your practice away from the point of diminishing or no return.