Every year during year-end-tax planning meetings I get asked “This particular customer owes me money, can I write this off?” To which my usual response is, it depends on whether or not your company is reporting on the cash or accrual accounting method. Bad Debt is what is being referred to when someone asks if they can write off what a customer owes them. When reporting for your taxes there are two types of accounting methods: cash basis and accrual basis. Let’s take a brief look at each and then answer that question.
This basis of accounting means that income and expenses are recognized when they accrue. Income is reported when the work is completed. Expenses are reported when the company receives goods or services. Both are reported regardless of money ever changing hands. Under this basis, a taxpayer could pay taxes on money never received.
Cash basis reporting means that you report your income and expenses when they are received and paid respectively. Income is reported once the cash is received from the customer. Expenses are reported when paid (via check, credit card, or cash). Most small businesses report under the cash basis reporting method. There are some businesses that either choose to report or are required to report under the accrual method.
Back to the question above, once I have determined which accounting method they are under I then answer the question with a yes or a no. Under the accrual method, the answer is a definite yes because the income was picked up already. Under the cash method the answer is no. Most of the time the response back is that the taxpayer is out that money. Cash basis taxpayers have never picked up the income so therefore would not be allowed to write it off. However, the taxpayer can and has already deducted expenses associated with that customer. For example, lets say it was a dentist that asked me this question, when performing the services that he is not going to get paid for he had to pay for supplies and labor that went into that customer. Those expenses were deducted when paid. So there is some write off associated with that customer.
If you have any questions on cash or accrual basis feel free to contact us.