This has come up twice for me recently so I decided it was worth a blog post and a video. Cash basis tax payers are still accrual basis businesses! I’m really not sure why there is even any confusion about this. In one recent case I was working with a bookkeeper who is helping an EA with their books for their own business. That scenario I can almost understand because the EA being a tax professional is accustomed to thinking of everything from the perspective of a tax basis of accounting.
Tax basis is not necessarily how we operate our businesses in the actual real world. Cash basis is DEFINITELY not how we operate in the real world.
In the real world I offer a service or I sell products. When someone agrees to pay for those services or products I deliver and now I expect to get paid. I don’t care what basis of accounting I am using when I file my tax returns. When I am running my business I need to take into consideration that people have promised to pay me for what I’ve delivered. If I ignore that, I’ll never collect my receivables and I’ll be out of business in short order.
We live and run our businesses on an accrual basis. We file taxes on a cash basis because as small businesses, if we had to pay taxes based on income we have not been paid for yet we would be out of business quickly. Outside of that, and in the real world we invoice clients with the expectation that they will pay us, especially once we’ve delivered the product or service they’ve agreed to pay us for.
If someone chooses not to pay us then WE REALLY DO HAVE BAD DEBT! We delivered, they didn’t pay. If that is not the definition of bad debt, I don’t know what is. I suppose if you want to create extra work for yourself, over complicate things, and run your company on a basis that has nothing to do with reality then you can keep your books on a strict cash basis, and never write off bad debt.
In my world, when someone doesn’t pay me and I’ve delivered I have bad debt. I will book the write off in the current year. Assuming the sale was made in a prior year, then on an accrual basis I had income in the prior year and an expense in the current year. On a cash basis I will have income in the year I wrote off the bad debt and applied it to the invoice. I will also have an expense in the same amount. It’s a wash. No additional taxable income will result.
If you have an LLC or some situation where gross receipts taxes are a concern, then set up the bad debt as an income account. This way it will all net out right in the top line of your Profit and Loss statement, and no additional taxes will be owed based on bad debt write offs.
The most important thing to me that you must understand and take away from this is that when someone agrees to pay you for something and you deliver but they don’t pay, then you have bad debt, regardless of how you file your tax returns!!!
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