Let me emphasize that in my previous post, I only addressed @chaz’s complaint that copying a sales invoice to a credit note left the tax amount in the Tax payable account. I wrote nothing about whether it was appropriate or correct to use a credit note to write off a bad debt.
I also wrote nothing about the effects on income and expense accounts. So let me expand. If you leave the line item on a credit note posted to the same account as on the original sales invoice, the income is removed from the income account. If you change the posting to a bad debt expense account, the income remains. But it is now offset by the bad debt expense. So the effect on the bottom line is identical. Either way, however, the tax amount is removed from Tax payable. Therefore, my initial comment that @chaz had not done things as stated appears correct.
The question of which transaction form to use to write off a bad debt is an entirely different question. Several factors could influence the decision. Most important is probably local tax law. Is the tax payable to the authority based on delivery of goods or services or payment for goods and services?
Frequently, it is the former, so removal of the tax from Tax payable would not be allowed. The government will demand its taxes, even if a business is unable to collect from its customers, on the principle that you should not have extended credit to an unworthy customer. In that case, a journal entry debiting the bad debt account and applying the tax code only to the credit to Accounts receivable is the right approach. This leaves the tax in Tax payable and the income in the income account. It puts the full amount, including tax, into the bad debt expense account, both offsetting the income and recording the tax expense you are now incurring on behalf of your bad customer. The net result is a loss on the transaction equal to the tax amount.
A similar result can be achieved with a credit note on which the line item is posted to the original income account, but the tax code is removed. This removes the income from the income account, but leaves the tax in Tax payable. However, the net loss on the transaction will not appear until tax is remitted, so somewhat delayed. That can be countered by modifying the line item to post the gross amount, including taxes, to the bad debt account and removing the tax code. This way, the result is identical to the journal entry described above and the net loss is reflected immediately.
On the other hand, if tax becomes payable only when you receive payment, then a journal entry debiting a bad debt account and crediting Accounts receivable can be used, but you should apply the tax code to both debit and credit. This removes the tax from Tax payable. It leaves the income in the income account and offsets only the income in the bad debt account. The net result on the P&L is zero.
This same result can be achieved with a credit note, too, by posting the line item to the bad debt account and applying the tax code.
So, whether tax is payable based on delivery or only collection, the accounting can occur via either journal entry or credit note. But which more accurately records what has happened? My opinion is that credit notes are not appropriate for writing off bad debts. They create the impression the debts have been forgiven when they have not. And they rob you of historical information on bad debt frequency and amounts. They also reduce your recorded income, distorting the picture of your productive sales or service activities. It is better, in my opinion, when the P&L shows both income earned and offsetting bad debt.
Further, in some jurisdictions, tax filings must, by law, include all return-adjusted sales, with bad debts being separately deducted. Although the credit note approach can (as outlined above) post to the bad debt account, it still suggests concurrence by your business with your customer’s bad behavior.
Another consideration, introduced late in the discussion by @chaz, is that a supposed bad debt can later be recovered. There is no way to reverse a credit note except with a new sales invoice, which does not seem appropriate. Nor would deletion of a credit note be correct, especially if the debt becomes recoverable in a new financial period. But a reversing journal entry is always acceptable.
So my personal preference is to record bad debts via journal entries.