How to Write Off Bad Debts in Xero: Step-by-Step Guide for Australian Businesses

Sometimes, despite your best collection efforts, a debt simply cannot be recovered. When that happens, writing it off correctly in Xero is essential — both for keeping your accounts accurate and for claiming a legitimate tax deduction. But getting the process wrong can mean losing the deduction entirely or triggering an ATO audit. This guide walks you through the exact steps to write off bad debts in Xero, the ATO requirements you must meet, and how to minimise bad debts in the first place.

What Is a Bad Debt?

A bad debt is an amount owed to your business that you have determined is uncollectable. This might happen because the debtor has gone bankrupt, disappeared, disputed the debt beyond resolution, or simply refuses to pay despite exhaustive collection efforts.

In Australian accounting and tax law, a bad debt is not just an overdue invoice — it is a debt that you have taken reasonable steps to collect and have concluded, based on objective evidence, will not be paid. The distinction matters because the ATO requires evidence that the debt is genuinely irrecoverable before allowing a tax deduction.

Common situations that lead to bad debt write-offs include:

• Debtor insolvency: The individual or company has been declared bankrupt or entered liquidation
• Business closure: The debtor's business has ceased trading with no remaining assets
• Uneconomical to pursue: The cost of further collection (legal fees, agency fees) exceeds the debt value
• Debtor cannot be located: Despite reasonable efforts, you cannot find the debtor
• Statute of limitations: The limitation period has expired (6 years in most Australian states)
• Negotiated settlement: You have agreed to accept a partial payment as full settlement, with the balance written off

ATO Requirements for Bad Debt Deductions

The Australian Taxation Office has specific requirements that must be met before you can claim a bad debt deduction. Understanding these requirements before processing the write-off in Xero ensures your deduction will stand up to scrutiny.

1. The Debt Must Have Been Previously Included as Income

You can only write off a debt that was previously included in your assessable income. For most businesses using accrual accounting (which Xero defaults to), this means the original invoice was recorded as revenue when issued. If you use cash accounting and the income was never declared (because payment was never received), you generally cannot claim a bad debt deduction — because there was no income to offset.

2. The Debt Must Be Actually Bad

The ATO requires that you have taken reasonable steps to recover the debt before writing it off. Simply deciding you cannot be bothered chasing it is not sufficient. Evidence of collection efforts should include:

• Copies of reminder emails and letters sent
• Records of phone calls made
• Any formal letter of demand issued
• Evidence of debtor's insolvency or business closure (ASIC search results)
• Cost-benefit analysis showing further pursuit is uneconomical
• Notes on any payment plan discussions or dispute resolution attempts

3. The Write-Off Must Occur in the Correct Financial Year

The bad debt deduction is claimed in the financial year in which you write off the debt — not the year the original invoice was issued. You must formally write off the debt in your accounting records (Xero) before the end of the financial year in which you want to claim the deduction.

Important: If you determine a debt is bad in May but do not process the write-off in Xero until August (the next financial year), you can only claim the deduction in the later year. This is why many accountants recommend reviewing aged receivables and processing write-offs before 30 June each year.

4. GST Adjustment Required

If you previously claimed GST credits on the original sale (which you would have if you charged GST on the invoice), you must make a GST adjustment when writing off the bad debt. This means you effectively "pay back" the GST component of the bad debt to the ATO. In Xero, this is handled through the credit note process when done correctly.

Step-by-Step: Writing Off a Bad Debt in Xero

Xero does not have a dedicated "bad debt write-off" button, but the process is straightforward using credit notes. Here is the exact process:

Step 1: Create a Bad Debts Expense Account

If you have not already done so, create a dedicated expense account for bad debts:

1. Navigate to Accounting → Chart of Accounts
2. Click Add Account
3. Set the Account Type to Expense
4. Name it "Bad Debts" or "Bad Debts Written Off"
5. Add a code (e.g., 6600 or whatever follows your chart of accounts numbering)
6. Set the tax rate to BAS Excluded (the GST is handled separately via the credit note)
7. Click Save

You only need to do this once. The same account will be used for all future bad debt write-offs.

Step 2: Create a Credit Note Against the Invoice

The credit note effectively reverses the original invoice, moving the amount from accounts receivable to your bad debts expense account:

1. Navigate to Business → Invoices
2. Find the unpaid invoice you want to write off
3. Open the invoice and click "Credit Note" (or go to Business → Credit Notes → New Credit Note)
4. The credit note should mirror the original invoice details — same contact, same amounts
5. Change the account for each line item from your revenue account to your Bad Debts expense account
6. Keep the same GST treatment as the original invoice (e.g., GST on Income). This ensures the GST adjustment is correctly calculated
7. Add a reference note such as "Bad debt write-off — Invoice #[NUMBER] — uncollectable"
8. Set the date to the current date (this determines which financial year the deduction falls in)
9. Click Approve

Step 3: Allocate the Credit Note to the Invoice

After creating the credit note, you need to apply it to the outstanding invoice:

1. Open the credit note you just created
2. Click "Allocate"
3. Select the original unpaid invoice from the list
4. Enter the full amount to allocate
5. Click Allocate

The original invoice will now show as "Paid" (technically offset by the credit note), and the amount will appear as an expense in your Bad Debts account. Your accounts receivable balance will decrease by the written-off amount, and your expenses will increase by the same amount.

Step 4: Verify the GST Treatment

After processing the write-off, check that the GST has been correctly adjusted:

1. Run the GST Audit Report (Accounting → Reports → GST Audit Report)
2. Check that the credit note appears as a GST adjustment
3. The GST component of the bad debt should reduce your GST collected for the period
4. This will be reflected in your next BAS lodgement

Step 5: Document Your Evidence

Attach your collection evidence to the Xero contact or the credit note for audit readiness:

• Open the credit note and use the Files attachment feature
• Upload copies of collection correspondence, letters of demand, and any ASIC search results
• Add detailed notes about why the debt was deemed uncollectable
• Include the date the decision was made and who authorised the write-off

Writing Off Partial Bad Debts

Sometimes you recover part of a debt and need to write off the remainder. For example, a debtor pays $3,000 of a $5,000 invoice, and you agree to accept this as full settlement.

The process is similar, but the credit note is only for the uncollected portion:

1. First, record the partial payment against the original invoice as normal
2. Then create a credit note for the remaining unpaid amount only (e.g., $2,000)
3. Allocate the line items to the Bad Debts expense account
4. Allocate the credit note to the partially paid invoice
5. The invoice will now show as fully settled

Recovering a Previously Written-Off Debt

Occasionally, a debtor you have written off will surprise you with payment. If this happens, you need to reverse the bad debt write-off:

1. Create a new invoice to the debtor for the recovered amount
2. Code the revenue to your Bad Debts expense account (this effectively reverses the original write-off)
3. Record the payment against this new invoice
4. The recovered amount will be included in your assessable income for the current financial year

Tax note: A recovered bad debt is assessable income in the year you receive the payment, not the year of the original invoice. Ensure your accountant is aware of any bad debt recoveries when preparing your tax return.

Bad Debt Provisions vs Write-Offs

There is an important distinction between a bad debt provision (also called a doubtful debt provision) and a bad debt write-off:

• Provision for doubtful debts: An estimate of debts that may become bad, recorded as a balance sheet adjustment. This is an accounting entry only and is not tax deductible under Australian tax law.
• Bad debt write-off: A specific debt formally written off as uncollectable. This is tax deductible when the ATO requirements are met.

For tax purposes, only actual write-offs count. Provisions are useful for financial reporting (especially for larger businesses following Australian Accounting Standards), but they do not provide a tax benefit. Small businesses typically skip provisions and proceed directly to write-offs when a debt is confirmed as bad.

End-of-Financial-Year Bad Debt Review

Best practice is to conduct a thorough review of your aged receivables before 30 June each year. Here is a practical checklist:

1. Run the Aged Receivables report in Xero (Business → Reports → Aged Receivables)
2. Identify all invoices over 90 days overdue — these are candidates for write-off
3. Review collection history for each — have reasonable steps been taken?
4. Check debtor viability — run ASIC searches for company debtors to check their status
5. Make write-off decisions — for each, determine if the debt is genuinely irrecoverable
6. Process write-offs before 30 June — ensure the credit notes are dated in the current financial year
7. Document everything — attach evidence to each write-off
8. Brief your accountant — ensure they are aware of all write-offs for BAS and tax return purposes

Minimising Bad Debts: Prevention Strategies

The best bad debt is one that never occurs. Here are practical strategies to reduce your exposure:

• Credit checks on new clients: Use services like CreditorWatch or Equifax to assess new client creditworthiness before offering credit terms
• Deposits and progress billing: Collect money before and during work, not just at the end
• Shorter payment terms: 7 or 14 days instead of 30 reduces your exposure window
• Automated follow-up from Day 1: Early, consistent reminders dramatically improve collection rates
• Online payment options: Make it as easy as possible for clients to pay
• Personal guarantees: For company clients, consider requiring director guarantees
• Retention of title: Register on the PPSR to protect goods supplied on credit
• Regular aged receivables monitoring: Review weekly, not monthly or quarterly

Xero Reports for Bad Debt Monitoring

Xero provides several reports that help you identify potential bad debts early:

• Aged Receivables: Shows all outstanding invoices grouped by age — the most important report for bad debt monitoring
• Aged Receivables Detail: Line-by-line breakdown of every outstanding invoice, useful for identifying specific problem invoices
• Contact Activity: Review individual client payment histories to spot patterns
• Profit and Loss: Monitor your Bad Debts expense account to track write-offs over time
• GST Audit Report: Verify that GST adjustments from bad debt write-offs are correctly reflected