Accounting Principles for the Valuation of Receivables

The Accounting Act stipulates that assets listed on the balance sheet must be reported in accordance with the principle of truthfulness. In the case of receivables, this means that the company must assess their expected recovery as of the balance sheet date. The valuation of receivables differs from that of other assets, as the basis for determining impairment in their case is not a comparison of book value and market value, but rather an assessment of the expected recovery of the receivable.

When valuing receivables, the company does not examine solely the legal status of individual receivables, but primarily assesses the debtor’s financial position, solvency, and the likelihood of recovery. The basis for recognizing an impairment loss is therefore the debtor’s credit rating, not merely the fact that the receivable exists.

According to the Accounting Act, an impairment loss must be recognized if the carrying amount of the receivable is long-term and significantly higher than the amount expected to be recovered. The accounting policy must specify the thresholds for differences considered significant for the purpose of recognizing impairment losses, as well as the rating procedures applied. When assessing permanence, however, the provisions of the Accounting Act must serve as the basis; as a general rule, the Act considers a decline in value that persists for more than one year or is final to be deemed permanent.

Accounting for Impairment

Impairment losses recognized on receivables are reported in the P&L as other expenses. However, the recognition of an impairment loss does not reduce the gross amount of the receivable; rather, it is recorded as a separate adjustment item. As a result, the receivable’s original book value remains on the balance sheet, while the impairment loss reduces its net book value.

If the prospects for recovery of the receivable improve, or if the recognized impairment becomes wholly or partially unjustified due to the debtor’s payment, it must be reversed; that is, the amount of the previously recognized impairment is credited against the receivable. The reversal is reported as other revenue in the P&L.

In accordance with the provisions of the Accounting Act, it is important to ensure that:
• analytical records are maintained of recognized impairment losses and their reversals;
• the valuation principles applied must be set forth in the accounting policies;
• impairment losses and changes therein must also be disclosed in the notes to the financial statements.

Accounting Treatment of Uncollectible Receivables

First and foremost, it is important to note that, according to the Accounting Act, uncollectible receivables may not be reported on the balance sheet, and once they are determined to be uncollectible, they must be written off from the books. Receivables for which the statute of limitations has expired or that can no longer be enforced through legal proceedings, among others, may be classified as uncollectible.

If an impairment loss had previously been recognized for the receivable, the receivable and the related impairment loss are offset. If a full impairment loss has already been recognized for the receivable, its write-off generally does not result in any further impact on the P&L. In the case of a partial impairment loss, however, the portion not yet covered is recognized as a credit loss.

Treatment of Impairment for Corporate Income Tax Purposes

The Corporate Income Tax Act does not automatically recognize impairment losses booked on receivables as tax-deductible expenses. Accordingly, in the year the impairment loss is booked, accounting profit decreases; however, pursuant to Section 8(1)(gy) of the Corporate Income Tax Act, a tax-base increasing item must be applied. Thus, in the year the impairment loss is booked, only the abovementioned adjustment is applied; no corresponding decrease in the tax base is applied. The purpose of this regulation is to ensure that accounting estimates made for expected losses do not, in and of themselves, result in a tax benefit.

If the impairment loss is subsequently reversed, the adjustment rules set forth in Section 7(1)(n) of the Corporate Income Tax Act ensure that the previously applied tax base increase is neutralized, thereby mirroring the tax treatment of the impairment loss recognition.

Uncollectible Receivables Under the Corporate Income Tax Act

The definition of an uncollectible receivables under the Corporate Income Tax Act does not always correspond to the definition used in the Accounting Act. The Corporate Income Tax Act allows a specified portion of certain receivables to be treated as a tax-deductible item even before they become definitively uncollectible under the provisions of the Accounting Act. An example of such a case is when a receivable has not been settled even 365 days after the payment due date, but has not yet expired and can still be enforced through the courts. In this case, the portion classified as an uncollectible debt under the Corporate Income Tax Act—up to an amount equal to 20% per year—may be treated as a tax-deductible item. As a result, a situation may arise in which the business has already recognized an impairment loss for accounting purposes and treated the amount as an item increasing the tax base, while the receivable is not yet classified as uncollectible for accounting purposes but may already be partially offset against the tax base under the Corporate Tax Act.

This results in a practical situation wherein the business has already recognized the impairment loss; it has treated the amount of the impairment loss as a tax-base increasing item; yet, while the receivable is not yet classified as uncollectible for accounting purposes, it may still be treated as an item reducing the tax base.

Statute of limitations on fully or partially impaired receivables

If a full impairment loss on the receivable was previously recognized, the amount of the impairment loss has already been treated as an item increasing the tax base under the corporate income tax system. If the receivable later becomes uncollectible, the portion of the tax base reduction that had not yet been claimed in previous years may be recognized in a lump sum in the year the receivable becomes uncollectible in terms of the Accounting Act. The purpose of this rule is to ensure that an impairment loss previously recognized as a tax base-increasing item can be claimed as a tax base-reducing item when the receivable actually becomes uncollectible, thereby ensuring that the loss is tax-deductible.

Different tax consequences may arise if only a partial impairment loss was recognized on the receivable.

With respect to the portion previously subject to an impairment charge, the adjustment mechanisms provided by the Corporate Income Tax Act may be applied. However, the portion of the receivable for which no impairment charge was previously recognized must be treated separately. If the portion of the receivable written off due to the statute of limitations does not qualify as a recognized expense under the Corporate Tax Act pursuant to Section 8(1)(d) of the Corporate Tax Act and, consequently, pursuant to Annex 3 paragraph A(10), the related credit loss may result in an item that increases the tax base without any corresponding item that reduces the tax base being applicable.

As a result, part of the same receivable may become settleable for tax purposes, while another part may be treated as a permanently unrecognized expense.

Receivables from Affiliated Entities

In the case of related parties, additional caution is required regarding this matter, as Section 7(4) of the Corporate Income Tax Act prescribes a special record-keeping obligation with respect to tax base adjustments related to transactions between related parties. Failure to comply may jeopardize the application of otherwise eligible tax base deductions; therefore, documenting the impairment and uncollectibility of receivables from affiliated companies is of paramount importance.

Management of Receivables in the KIVA System

In the small business tax system (KIVA), the treatment of impairment losses recognized on receivables differs significantly from the rules of corporate income tax.
While the corporate income tax system includes items that increase and decrease the tax base in connection with impairment, the determination of the KIVA base generally does not follow the changes in accounting impairments. Consequently, the recognition of an impairment loss does not in and of itself result in an adjustment to the KIVA base and the reversal of an impairment loss also does not automatically affect the tax base.

A particularly interesting issue is the subsequent expiration of a receivable that has been fully written off. If a 100% impairment loss was previously recognized on the receivable, the entity’s loss was already realized from an accounting perspective in the year the impairment loss was recognized. When the receivable subsequently becomes uncollectible, the reversal of the receivable and the related impairment loss does not result in any further impact on profit or loss; therefore, no expense to which Section 20(3)(d) of the KIVA Act would apply is recognized in the year that it has become uncollectible. Accordingly, the write-off of a receivable that has been fully impaired does not give rise to an item increasing the KIVA tax base. This interpretation is also supported by specific professional guidance from the National Tax and Customs Administration (NAV).

This issue requires particular caution in the case of receivables from related parties, as the KIVA Act’s special tax base adjustment rules applicable to related parties may result in a tax base adjustment even if they are partially independent of general accounting logic.

Summary

The treatment of impairment of receivables follows different logics from the perspectives of accounting, corporate income tax, and small business tax. While accounting emphasizes the principle of expected recovery, the Corporate Income Tax Act and the KIVA Act apply their own adjustment mechanisms. For proper tax treatment, it is therefore necessary in every case to examine separately the timing of the impairment recognition, the subsequent fate of the receivable, the legal basis for uncollectibility, and whether the receivable is owed by a related or unrelated party.

Disclaimer: this article is a translation of our original article written in Hungarian, which you can find here.