Booking cancelled debts
When your company’s debt is forgiven, you include the cancelled amount in gross income for tax purposes. The exception is cancellation of a debt to the extent that the payment would have been a deduction.
Problem: SmallCo uses a consulting firm from it which it obtains services on credit. SmallCo has trouble paying its debts, but is neither bankrupt nor insolvent, so the consulting firm forgives part of its invoice to SmallCo. If you are SmallCo’s bookkeeper, how do you book the cancellation?
Solution: The solution depends on SmallCo’s method of accounting:
- If SmallCo is on the accrual basis, it includes cancellation of the debt as income because, under the accrual method, expenses are recognized when incurred, not when paid.
- If SmallCo is on the cash basis, it does not include the debt cancellation in income because payment for the services would have been a deductible business expense.