What it means
Under accrual accounting, a business records income when it earns the right to be paid, not when the cash comes in. That means a firm can owe tax on invoices that later turn out to be uncollectable.
Normally the only relief is a deduction for a bad debt once the account is actually written off. The nonaccrual experience method offers an alternative for qualifying taxpayers.
Instead of waiting for a specific bad debt, the business estimates how much of this year's billings will not be collected, based on its own past experience, and does not include that amount in income to begin with. The rule is found in the US tax code and has conditions about who may use it.
In general it is available to businesses that provide services, such as law, health, accounting, consulting and engineering firms, and to smaller businesses whose average annual receipts are below a limit set by the tax authority. Businesses must follow a prescribed formula, typically using a moving average of several prior years, and must generally apply it consistently across all their accounts.
The method does not apply to interest or penalties charged on late payments, and a business that uses it cannot also take a separate bad debt deduction for the same amounts. If a customer later pays an amount that had been excluded, the money is included in income when it is collected.
The practical benefit is cash flow, because a firm does not pay tax in advance on income it does not expect to receive. The cost is record keeping, since the business must track billings and write-offs for several years and apply the formula correctly.
The eligibility rules and size limits are set and adjusted by the tax authority. Businesses should confirm the current conditions with a tax adviser before adopting the method or changing to it.
In practice
Real-world examples.
Example
A small law firm bills $900,000 in a year and has a six-year write-off rate of 3%. It excludes $27,000 of the billings from its taxable income using the method, because $900,000 x 0.03 = $27,000. The partners no longer need to argue each year about which clients' bills count as bad debts.
Example
A physiotherapy practice that bills patients and insurers has historically failed to collect about 4% of its bills. By using the method it reduces its taxable income by $20,000 on $500,000 of billings. The practice administrator updates the percentage each year as older years drop out of the six-year window.
Example
A firm of engineers has an unusually good record, with only 0.5% of billings uncollectable. The exclusion is small at $2,500 on $500,000 of billings, but it saves time compared with identifying individual bad debts. The finance team uses the same schedule to explain collections to the partners.
Formula
Calculation
Nonaccrual percentage = Total uncollectible amounts in the last six years / Total billings in the last six years
A consulting firm billed a total of $1,500,000 over the previous six years and wrote off $30,000 of that as uncollectible. Percentage = $30,000 / $1,500,000 = 0.02, or 2%. This year the firm billed $400,000, so it may exclude $400,000 x 0.02 = $8,000 from taxable income, and its taxable billings become $400,000 - $8,000 = $392,000. If the firm's tax rate on profit were an assumed 25%, the exclusion would reduce tax by $8,000 x 0.25 = $2,000 for the year.Case study
Seen in the real world.
Winterbourne Advisory is a fictional accounting practice invented to illustrate this idea. It billed $1,200,000 a year, collected most of it, but wrote off roughly $36,000 of fees each year after clients disappeared or disputed bills.
The practice manager noticed that tax was being paid on income that never arrived. After consulting an adviser, she adopted the nonaccrual experience method, calculating a 3% rate from six years of billings and write-offs.
In the first year the firm excluded $36,000 from income, which reduced its taxable profit and brought forward the tax benefit. The manager also set up a simple spreadsheet to update the six-year figures each year-end, and made sure the practice did not claim the same write-offs a second time as bad debts. Her adviser reviewed the calculation once to confirm that the practice qualified as a service business under the tax rules.
Watch out
Common mistakes.
- Claiming both an exclusion and a bad debt deduction for the same amounts. The rules prevent a double benefit.
- Using only one year of data. The method generally requires an average over several past years.
- Assuming every business can use it. Eligibility depends on the type of business or its size, as set by the tax authority.
Questions
People also ask.
What is the main benefit of the method?
It lets a business avoid paying tax on income it does not expect to collect.
What happens if a customer pays later?
The amount collected is included in income when it is received.
Does the method apply to interest charged for late payment?
No. Interest and penalties are normally excluded from the method, so they are taxed in the usual way when they are accrued.
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