A sale made by a company that extended credit to a customer creates an account receivable. Depending on the method of accounting used by the company, the income will be included in taxable income either at the time the sale is made or at the time the account is collected. In either case, the company must have a profit for tax purposes before it pays income tax.

Cash Method

If a company uses the cash receipts method of accounting, income isn’t included in taxable income until cash is collected. Under this method, a sale on credit has no effect on income. Most service businesses are permitted to use this method for tax purposes.

Accrual Method

If the company is one that derives its income from the sale or manufacture of inventory, it is generally not permitted to use the cash method, unless its gross receipts are under $1 million. Companies that don’t meet this exception must include an account receivable in taxable income at the time the sale is made. This is known as the accrual method. Under Generally Accepted Accounting Principles, the rules accountants follow in preparing financial statements, the accrual method is prescribed because it provides a more accurate picture of a company’s financial results.

Bad Debts

If a company uses the accrual method for its accounts receivable, it will include in taxable income some receivables that may not be collected. When the company determines that a receivable is uncollectible, it can deduct it as a bad debt. If the company uses the cash method, there is no bad debt deduction since the company didn’t report the income when the sale was made.

Dual Methods

A company can use the accrual method for its financial statements and, if it is otherwise permitted to do so under the tax rules, the cash method for its tax returns. The statements will show the sales and accounts receivable that have been attained, but the company will not be taxed on receivables that have not been collected.