I’m not paying taxes on money that’s not in the bank, right?

This was a question from a client and highlights an area commonly assumed by accountants to be understood by their clients.

It’s reasonable to assume that a business (limited company or sole-trade/partnership) is taxed only on the cash actually received. After all it’s hardly fair to be taxed on sales which are never paid for, ie bad debts. But that’s not strictly the case. To understand what a business pays taxes on we need to examine how and when a “sale” is recognised.

Recognising a sale

A sale is generally recognised when an invoice is issued. But if that were the only criteria then the system would be open to manipulation and abuse. For example, you could ship goods to a customer on the last day of the year and issue the invoice in the new year. This would distort the profits as the sale was clearly agreed and concluded (as evidenced by the dispatch of the goods) in the old year. Conversely, you could raise an invoice in the current year but not dispatch the goods and send the invoice until the new year, inflating profits in the current year, perhaps to meet sales targets to please shareholders and/or get a bonus. Accounting rules are designed to prevent such manipulation and tax rules generally follow those rules.

Businesses should review their sales “cut-off” at the year-end to ensure all sales that have been completed have invoices issued and the sale recognised. If the invoice has not been issued an adjustment should be made in the accounts to reflect this.

Service companies and work-in-progress

A service company should calculate work in progress at the year end. This calculation is designed to recognised profit which has effectively been earned (ie work done) but not yet invoiced. The work need not actually be complete. The work-in-progress calculation also recognises future losses. There are specific rules and methodologies for calculating work-in-progress which is beyond the scope of this blog so you should seek help from your accountant when approaching this.

Bad debts

If a customer doesn’t pay, and it looks like they may never pay, you can recognise this in your accounts by treating it as a bad debt. This is often referred to as “writing-off” the debt. The transaction removes the debtor from your balance sheet and charges an expense in your profit and loss account. The sales are not reduced directly; instead, the bad debt is shown as an expense.

Some businesses make a general provision for bad debts, usually based on past experience. For example, the may have found that historically 5% of debtors don’t pay so they make a provision to recognise these potential bad debts. This general provision is not allowable as an expense when calculating taxable profits, but is perfectly acceptable when calculating accounting profits. An adjustment is made in the tax computation to allow for this. Businesses can also make specific provisions for bad debts. This is where particular customers or invoices have been identified as being unlikely to be received. Provision is made for these in the accounts and is an allowable expense for tax purposes.

Written-off…but not forgotten

A common misconception is that a debtor that has been written-off as a bad debt in the accounts is gone and cannot be pursued. You’re not telling the customer that the debt has been written-off, of course. This is an accounting transaction only and there is nothing to prevent the business from continuing to pursue the customer for payment.

So, to answer the question…

Yes, you are paying taxes on money that’s not in the bank. But, if you’ve reason to believe that you won’t ever receive the money, then, you won’t pay taxes on it.

 

 

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