Bad Debt ExpensePosted on September 23rd, 2016
The IRS requires companies with the average revenue of $1 million in the past three years to use the accrual method of accounting in order to prepare their financials to file income tax returns. The accrual method requires you to report income in the year that it was earned and expenses in the year it incurred.
So for example, if you perform a service for a customer, such as painting a room or presenting someone in court, in December 16, 2015, but do not receive payment for your services until February 2, 2016, you must report the income for this service in your 2015 tax return, because the income was earned in 2015.
The opposite can also apply if you receive an advance payment. For example if you are booked for aperformance in March of 2016, you may require your customer to pay a partial payment at the time of booking, which may have been in November of 2015. Since you have not yet earned this income, you must report it when you file your 2016 return.
You may ask, “What if I report an income earned in 2015 on my return and pay taxes on it, but the client never pays me?”
This type of situation unfortunately happens all the time. For many companies this may mean thousands of dollars reported in income that end up never being actually collected. The term that the IRS uses to describe this is bad debt.
There are two methods used to calculate and report bad debt on corporate returns. One is direct write-off method and the other is the allowance method.
The direct write-off method is an entry to debit Bad Debt Expense and credit Accounts receivable at the time that the uncollectible accounts are identified. Meaning if in 2016 you find that you can no longer collect an amount reported in 2015 income tax return, you may expense it in your 2016 tax return and use it as a deduction in 2016 taxes.
The allowance method is preferred by companies who prefer to not pay taxes when they don’t need to. To use this method you must estimate the amount of bad debt you expect and create a contra asset account under Accounts Receivable in the balance sheet to show a more realistic amount expected to be collected. You also report the expected amount of bad debt expense from the earned income in a particular year, in that same year.
Both of these methods can get very confusing for people that have not been trained in accrual accounting method and are best left to the pros. If you think it’s time to discuss which method is best for you in order to save more taxes give us a call.
For more information on bad debt refer to Topic 453 on the IRS website.