The nonaccrual experience method (NAE) is a tax accounting procedure that the Internal Revenue Code (IRC) uses for handling bad debts. The procedure can only be applied to bad debts for services that were performed in a few select professions. Also, the company that the NAE method is being applied to must have less than $5 million of average annual gross receipts in previous tax years.
Understanding the Nonaccrual Experience Method
The Internal Revenue Service (IRS) is a governmental organization that is responsible for collecting taxes on behalf of the U.S. government. The IRS developed the Internal Revenue Code (IRC), which is essentially the tax code of the United States that covers rules related to the taxation of individuals and corporations.
The application of the nonaccrual experience method is when a company incurs bad debts. Companies incur bad debts when they cannot collect money that they are owed from customers.
Bad debts that are not claimed on the business’s tax return using the NAE method can be claimed under other charge-off methods as well. In fact, charge-offs are actually more common.
A charge-off is a debt that is deemed unlikely to be collected by a creditor from a borrower. It results in writing off the debt from the balance sheet, as well as expensing the lost funds on the income statement in the form of an expense.
How It Works
Under the NAE method of accounting, the company can estimate the debt that will end up being bad based on their own past experiences and historical records with customers, suppliers, and debtors. It is a favorable method since a company does not need to write off their entire debt balance if they expect that some of it may be collected down the line.
It allows certain service providers to be exempt from the accrual portion of the revenue that they have determined is unlikely to be collected based on their experience and formulas allowed under the Securities Exchange Commission (SEC) regulations. However, it can only be applied to companies that operate in the following industries:
Regarding the NAE rule, a taxpayer can use the NAE method of accounting if the company uses the accrual method of accounting when recording revenues for services performed by the company, operates in one of the above industries, and the company has earned less than $5 million in gross receipts in one of the previous three years.
Accrual Method of Accounting
The accrual method of accounting is a method in which the revenues and expenses are recognized when they are incurred, not necessarily when cash is exchanged. It is in contrast with cash-based accounting, where revenues and expenses are recorded when the cash actually moves.
Therefore, under the accrual-based accounting method, revenue is recognized when it is earned. For service providers such as the companies that fall under the domain of the NAE method, it means that the revenue is recognized when the service is provided. It can result in amounts owed from customers for services that have been provided in the past. Bad debts may arise when customers are unlikely to pay for such services.
NAE Book Safe-Harbor Method
A safe harbor is an accounting method within legal or tax regulations that allows the avoidance of the regulations. However, it also refers to when a tax regulation is made simpler in certain conditions when applying the tax code. The NAE book safe-harbor method allows companies to exclude qualifying uncollectible revenues from their taxable income, which is favorable for reducing the amount of taxes paid.
The NAE book-safe harbor method is generally easier than qualifying for other safe-harbor methods but can only be used by companies in the NAE-designated industries. Some safe harbor methods are difficult to utilize due to the historical information required to qualify.
For example, under some safe harbor methods, it is required that a company has financial information that is tracked for six years. Sometimes, it may be difficult to find all of the relevant information and qualify for the safe harbor methods.
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