As a small business owner, you may be wondering why you have to pay taxes on invoices that haven't been paid yet. In this post, we'll explore the reasons why and how to handle it.
Sole Trader
If you're a sole trader, you have the option to trade using different accounting rules. These are called cash accounting or accrual accounting. Cash accounting bases everything on the bank statement - so when money is received, it’s logged as income, and when cash is paid out of the bank, it’s logged as a cost. Accrual accounting is a bit more complex in that you log the income or cost on the date the tax point occurs - which is usually the invoice date. Accrual accounting means that you may see scenarios where an invoice is sent in one tax period, but paid in the following one. If this is the case you'll end up being taxed in the first period.
Limited Company
All Limited companies use accrual accounting. There is no choice. There are specific rules governing how this should be done; an example of these rules is Financial Reporting Standards.
Accrual accounting isn’t all about invoices though. When preparing your year-end accounts, you should be looking for outstanding purchase invoices, as well as timing adjustments such as prepayments and accruals. Completing these timing adjustments correctly makes accrual accounting really useful to determine the actual profits of a tax period.
Tax Relief for Specific Bad Debts
When using accrual accounting, there’s a chance you might end up being taxed on an invoice that doesn’t end up being paid. When an invoice hasn't been paid for a long time (over 6 months), you have the opportunity to declare it a bad debt and write it off. If you do this, you’re effectively telling HMRC that you’re not going to chase for payment of the invoice anymore, and you get tax relief when doing so (in the year that you declare the bad debt). The bad debt shows as an expense in your accounts, and this offsets the income that showed on the original sale.
No Tax Relief for General Bad Debt Provisions
Tax relief on bad debts only applies when you’re writing off specific invoices as bad debts. If you regularly have bad debts, you might want to put a provision in the accounts for bad debts. But because these provisions aren’t allocated to specific invoices, you don’t get tax relief.
In conclusion, as a small business owner, it's important to understand the accounting rules that apply to your business. By doing so, you can make informed decisions and avoid surprises when it comes to paying taxes on invoices.