A common question that clients ask us is this: “May my business claim a deduction when a customer fails to pay us?” The answer is, “It depends.”
Every business must adopt a “method of accounting” in its first tax year. This is the method by which it reports its income and expenses on its income tax returns. There are many accounting methods, but the two most common are the accrual method and the cash method.
The accrual method of accounting means that income is taxable when it is invoiced to a customer (and expenses are deductible when the business receives a bill from a vendor for work completed or items purchased). Under the accrual method, the business will report income that it has not received (accounts receivable). Therefore, under the accrual method of accounting, a business can claim a deduction for bad debt once it is clear that a customer will never pay an invoice that was previously included in income.
By contrast, under the cash method of accounting, a business reports income as taxable only when it is received, rather than when it is invoiced. Under this method, there is no deduction available for unpaid customer invoices because the business will not have reported the invoice as income in the first place.
Many small business clients use the cash method of accounting, but some retailers, contractors, and other businesses use the accrual method. It is important to realize that, over time, the two methods will produce the same amount of taxable income, so the choice of accounting method in the first tax year of a business usually boils down to this: Will the business have accounts receivable from unpaid invoices in the first year that are greater than the business’s accounts payable? If so, then the cash method is advantageous in the first tax year. Given the time value of money, an advantage in the first tax year is better than an advantage in a later tax year from the accrual method.
Also, note that some businesses are required to use the accrual method. This includes large businesses that maintain inventories.
If your business has adopted an accounting method that it now wants to change, it is possible to do so, but the process is complicated. It might make sense, however, in some situations. For example, we recently helped a construction contractor change from the cash method to the accrual method because it receives a large amount of contract deposits each year (which are taxable when received under the cash method but not until the contract is completed under the accrual method).
