I recently had a client ask me why the books show income and then show a bad debt expense when they write off an invoice. If they didn’t get paid on it, why is it income. They were mad that the income is showing up at all. This post is my response to the client trying to describe why accounting rules do it that way.
“The reason lies in accrual accounting versus cash accounting.
In cash accounting you book as income money you collect, and you book expenses when you write out the checks. There is no bad debt or invoice write-offs in cash basis. You didn’t receive the money in the first place so there is nothing to write off.
In accrual, you show income when you invoice. Accrual doesn’t care what gets deposited. When you get a bill, you book it as an expense. Accrual doesn’t care if you ever write the check out. So because of this, if you send an invoice (which is now income on your accrual books) that doesn’t get paid and you don’t feel like you are ever going to get paid, you “write it off”. Remember that your books already show income. Income that isn’t real and never will be real. The bad debt expense is then used to write off the invoice. This offsets the income that never should have been income. However, but having the invoice show as income and then having bad debt as an expense, you can easily track year of year by looking at your profit and loss how the business is doing in selecting dirt bag customers.
Both methods get us to the same result. You don’t pay tax on invoices that go bad. The company gets the loss because the actual expenses that happened while providing the service are on the profit and loss because you actual paid out that money. ”
As a general rule of course, try to avoid crap heads that aren’t going to pay you.