Nonaccrual Experience Method of Accounting
Businesses frequently offer customers credit and receive payments after performing services or providing customers with products. This approach can lead to bad debts for a company that extends its credit. The nonaccrual experience method is an accounting procedure that allows businesses to exclude from income any amounts not collected because of a bad debt.
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Bad Debt
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A company incurs bad debt when it cannot collect the money customers owe. In certain cases, Internal Revenue Service code allows the business to claim a bad-debt deduction. This tax savings can in some ways help to make up for the loss incurred from the bad debt. To qualify for this tax deduction, the debt must result from business operations, and the business must classify the debt as worthless, meaning there exists little chance for the business to collect the debt from the customer. Businesses can account for the bad debt by either using the nonaccrual experience method or the specific charge-off method.
IRS Guidance
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According to the IRS tax code, certain companies and service providers can deduct uncollectible amounts from their gross income when preparing tax returns. Any business using an accrual method of accounting can exclude amounts that it does not expect to collect based on prior experience. The accrual method of accounting requires a business to record taxable income at the time it performs a service or provides goods. In other words, when using the accrual method, a business will account for a sale prior to receiving payment from a customer. A business cannot deduct bad debt using the cash method of accounting because this method requires the business to wait for payment before recording taxable income.
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Nonaccrual Experience Method
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When using the nonaccrual experience method, a business does not accrue service-related income that it feels it cannot collect based on previous experience. The IRS allows businesses to use this method only if the business made less than $5 million in the three previous accounting years. In most cases, businesses use this method to deduct bad debts for accounting services, consulting or for legal, engineering, architectural, health or artistic purposes. When using NAE, the business will not include the bad debt in the gross taxable income.
Deduction Methods
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The specific charge-off method permits full or partial deduction of any debt that becomes worthless during the tax year. Any service provider can use this method, and the result should be the same as applying the nonaccrual experience method. If a business receives a tax deduction based on the exclusion of a bad debt but later manages to collect the debt, the business must report the collected amount as income.
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