Stuck With a Bad Debt?

Most business owners assume that when a customer does not pay for a service or product, it can be written off as a bad debt against the business.  

Unfortunately, that is probably not the case.  Most small businesses keep their books by using the cash method of accounting.  Thus, they never include into income payments that have not actually been received, nor do they deduct expenses that are owed but have not actually been paid.  Therefore, if a customer fails to pay you what he or she owes, it is not in your cash basis income and, as a result, you cannot, in turn, back it out again as a bad debt.

Let’s take, for example, a self-employed gardener with a customer that moves out-of-state without paying his outstanding balance.  He owes $1,000 for a couple months of gardening service. 

The gardener cannot deduct what has not yet been received as income.  Let’s assume that the deadbeat customer was his only account for the year and owed $1,000 for labor services when he took off.  Since a payment was never received, the income on the gardener’s books for the year would be zero.  If he were to write off the $1,000 as a bad debt, he would be claiming a $1,000 loss, which is clearly not the case.  So, even though he expended his energy servicing this customer, he cannot have a bad debt for an amount that was not paid.