There are clear rules around writing off a bad debt in the Sales Ledger, but the question of writing off a credit debt in the Sales Ledger appears not to have such clear guidance. As a result it is something of a contentious issue, not only over how to write such balances off, but whether they should be written off at all.
The HMRC refer to credit balances due to customers as unclaimed balances (HMRC Internal manual bim41810) and includes,
‘sums derived from a trader’s customers described as ‘unclaimed balances’, ‘overpayments’, ‘windfalls’, ‘voluntary payments’, ‘double payments’, ‘payments by mistake’, ‘sums written back’, etc. Such sums also arise if a supplier fails to ask a trader for money properly due, or asks for less than is properly due or refunds money in error.’
In most cases a customer overpayment would be noticed early and rectified by paying it back, job solved. But this is not true of all cases.
Scenario: You inherit a Sales Ledger with a collection of credit balances huddled in the ‘overdue’ column. An investigation reveals that overdue is an understatement, they have begun to grow beards. It appears that normal trading has ceased, the customers have stopped trading, been declared insolvent or just fallen deathly silent. Either as a result of internal policy or a wish not prejudice the debtor days calculation ( a key indicator of business health) in the pursuit of ‘fair and true’ you want to remove them from the Sales Ledger and consider writing them off.
Due to the number of variable factors there is no ‘one size fits all’ answer for writing off customer overpayments and, by virtue of its nature the notion often raises questions around Theft and Money Laundering
Theft and Money Laundering
According to the 1968 Theft Act :‘(1)A person is guilty of theft if he dishonestly appropriates property belonging to another with the intention of permanently depriving the other of it; and “thief” and “steal” shall be construed accordingly’
To fall under the heading of dishonest appropriation you would have to consider if the transaction was in itself, dishonest, or if there was any form of coercion or encouragement involved that led to the overpayment.
Any suspicions of this nature could mean the issue automatically falls under the rules around Money Laundering and the obligation to report to the NCA.
Dishonest appropriation apart, customer overpayments are specifically covered in the CCAB’s money laundering guidance.
Guidance to report is given,
‘where there is evidence of a dishonest intention to retain the overpayment eg: hiding an overpayment by omitting it from statements or crediting the profit and loss without attempting to contact those who overpaid’.
The HMRC recognise that, ‘In some trades the occurrence of unclaimed balances is an everyday event, in others they may be extremely rare.’
Due to their nature HMRC will review them and scrutinise documentary evidence to establish the terms and conditions of the transaction and the precise nature of the relationship between the parties. Similar to the guidance around money laundering, under HMRC internal guidelines a review will aim to establish:
- the circumstances giving rise to the creation of unclaimed balances and to their treatment in the accounts.
- the frequency with which such balances arise.
- the steps the taxpayer has taken to alert the other party to the transaction that an unclaimed balance has arisen and continues to exist.
- the correct accountancy treatment at all stages
Avoiding the requirement to report an outstanding customer overpayment to the NCA depends on having prior and current evidence of honest intention.
Why not just pay it back anyway?
Even if the overpayment is established as being an error on the customers part, paying it back may not be straight forward. The scenario above is based on a real situation which does not seem to be in any way unique. The older the transaction the more problematic the solution and the greater the possibility that a trading relationship and any contact with the customer has been terminally lost.
With a customer you are still able to contact there is no guarantee that they will agree the error is theirs and may dispute the repayment.
Where it is disputed the debt can be released by means of a formal waiver from the customer. This would provide evidence to validate the write off especially it could be considered material
Even if you send a cheque regardless, the debt is not discharged if the customer doesn’t present the cheque for payment.
In accounting, materiality refers to ‘the impact of an omission or misstatement of information in a company’s financial statements on the user of those statements. If it is probable that users of the financial statements would have altered their actions if the information had not been omitted or misstated, then the item is considered to be material. If users would not have altered their actions, then the omission or misstatement is said to be immaterial.’
For most SME’s materiality is likely to have a greater impact simply because they are, by definition, small.
Under Accountancy standards, In terms of monetary value materiality calculated as being more than 0.5% – 1% of turnover.
How to and when to Write off a Credit Debt.
There are few circumstances where a debt will be formally discharged apart from accepting a repayment, other than under a contractual agreement. Under HMRC guidelines, the debt will remain valid even if the customer writes off the debt, fails to demand payment, has become bankrupt or insolvent.
Though fundamentally influenced by GAAP rules, HMRC’s view of customer overpayments is governed in large by the judgement of the Pertemps Recruitment Partnership Ltd case (detailed at the foot of this article)
Under this ruling a Supplier has ‘power and possession’ over customer overpayments albeit with a duty to repay them should the customer make a valid claim. Also, as the overpayments occur as a result of a trading relationship, but not as a result of normal trading they are seen as taxable income in the period the overpayment is realised ( written back to income in the Profit and Loss).
Because there is no consideration and the value of the supply is not changed, customer overpayments are out of scope of VAT.
As the income did not occur due to normal trading and may come under scrutiny, it is perhaps wise to enter them under the category of ‘other income’ and practice due diligence retaining supporting documentation to support the entry.
The decision to write off a credit debt shouldn’t be taken without some prior consideration and efforts made to rectify the situation if possible.
- Were ‘reasonable’ attempts made to return monies due
- Has the debt been retained on a Customer’s Account for a ‘reasonable’ length of time to allow the Creditor to claim a refund.
- Are you acting in compliance with the internal business policy of the client or employer.
- Can the debt be considered ‘time barred’ under the Limitation Act.
Even if the debt is written off, it will remain a potential liability to the business.
The Limitations Act 1980
The Limitation Act, to protect the interests of the Debtor, only applies to civil claims and the time civil proceedings must be started. It has ramifications for a business, in particular how long records should be kept by the party who might have reason to make a claim.
In most cases that fall under the Limitation Act 1980 the limitation period is 6 years and will begin from when the cause of action happened. So for our case, it would be the date the overpayment was made. But this only applies if there has been no contact.
If the creditor (the customer) has made contact to demand payment, the start date will be amended to the date of the last communication making the effective period longer than 6 years.
The acknowledgement has to be a signed letter or email. Correspondence from the Debtor to the Creditor doesn’t count, neither does a phone call.
After the limitation period a Debtor can use the defence of ‘time barred’ against any claim, but it must be in writing ahead of any legal action.
In 2010 the act was amended introducing:
- The concept of ‘late knowledge’. Allowing a creditor a further 3 years to issue proceedings if a claim discovered before the end of a limitation period. There is however, a 15 year absolute ‘longstop’ by which all claims must be brought whether or not the person knows they have a claim.
- Permission for parties to contract out of, or modify, the terms of the Act. This means that businesses and individuals should be cautious when negotiating and signing agreements as to how long a potential claim in relation to the contract could persist, and for how long they should retain records of the events.
If a debt becomes ‘time barred’ it still remains a liability but can no longer be persued through the legal system. This could be viewed as sufficient evidence to ‘release’ the liability and write it off to the Profit and Loss as taxable income.
Given the number of variable influences and legal connotations, Its perhaps not such a surprise that there is no definitive answer to the treatment of credit debts on a debtors ledger. Such events should be a rarity, but they do happen and should subject to due diligence when deciding what action to take.
Once it is established that they can’t be rectified or discharged, in the interests of best practice and accounting standards, consideration should be given to transferring any outstanding credit balances from the debtors ledger. Either reclassifying them as taxable income immediately, or as a liability on the balance sheet first. The most appropriate method however, will depend on judgements around relative value and age of the debt and the trading status of the customer.
Perhaps the last word should be given to GAAP Principle of Materiality which has an influence over all factors when considering how to resolve the dilemma.
• Then there are a couple of principles which require the bookkeepers to use their judgement rather than sure shot rules. There are inaccuracies in all accounting records. After all, nobody is perfect. But when errors are made how important are they for the book keeper to break his head over. A ten dollar error can be ignored, but not a thousand dollars one. This is where the principle of materiality comes in and this is where the accountants have to use their judgements.
The final conclusion to perhaps draw from this dilemma is that it highlights possible weaknesses in current policy and procedure around credit control and its worth looking to see if they can be improved to prevent any problems in the future.
Pertemps Recruitment Partnership Ltd Case
The First-tier Tribunal found as a fact that each of the overpayments was made by a customer under a mistaken belief that it owed money to Pertemps for services Pertemps had supplied to it. In this sense, the payments were not wholly gratuitous, rather derived from the business relationship that had existed between Pertemps and its customers. The payments were of sums of money to which, on receipt, Pertemps was not entitled in the sense that Pertemps was obliged to make such a full refund if requested by the customer. Furthermore, Pertemps did not carry out any specific trading activity to earn or encourage the mistaken payments, but receipt of the mistaken payments was an unavoidable incident of Pertemps’ trade. In this sense, the true source of the payments was the trade and not the mistake.
1. a receipt was to be judged once and for all at the time of receipt, and
2. a payment cannot be a trading receipt unless the trader has a legal entitlement to receive it at that time
Arnold J rejected both arguments in the Upper Tier Tribunal citing past precedent to arguing that entitlement is not essential for a trading receipt and the recipient is legally entitled to receive and keep the money until a claim for repayment is made and established.
It was also ruled that if it is not possible to establish that an overpayments are taxable, they should be referred to buisness profits with supporting documentation.
Pertemps traded as an agency providing either temporary or permanent workers to its customers. Customers were invoiced on a monthly basis and all payments, whether reconciled to invoices or not, were credited directly to Pertemps’ bank account. Pertemps tried to match payments to outstanding customer liabilities. In most instances, Pertemps was able to offset the payment against a liability or repay the customer. In a minority of cases some payments were neither offset nor repaid. At six monthly intervals Pertemps reviewed the unreconciled balances in the sales ledger and transferred any over six months old to a balance sheet account. At the end of the financial year, Pertemps released the balance sheet account to profit and loss. This accounting treatment gave a true and fair view and was in accordance with GAAP. If a customer could show that they had made an overpayment, Pertemps’ policy was to refund even if the amount in question had been transferred to a balance sheet account or been released to profit and loss.
Pertemps did not know why customers made payments in error, the behavioural drivers behind the customers’ actions was not important, but they fell into three categories:
- payments were made against invoices, notwithstanding that the invoice had already been reversed by a credit note
- invoices were paid twice, perhaps because a credit note was mistaken for an invoice
- in one case the receipt could not be linked to an underlying supply or invoice, although there may have been a previous customer relationship