Nonaccrual Experience (NAE) Method

The Nonaccrual Experience (NAE) Method is an accounting approach allowed under the Internal Revenue Code for handling bad debts on an accrual basis. It permits certain service providers to exclude from income the portion of revenue they determine, based on their historical experience and permitted formulas, is unlikely to be collected.

Key takeaways

• NAE lets eligible accrual-basis service providers avoid recognizing revenue they expect to be uncollectible, based on past experience.
• It applies only to specified service fields and is subject to a small‑business gross receipts threshold.
• Taxpayers may use approved safe-harbor formulas or request IRS consent to use a formula that reflects their specific experience.
• If not using NAE, bad debts are generally claimed under the specific charge-off method.

Who can use NAE

NAE is limited to taxpayers who:
* Use an accrual method of accounting for service revenue, and
* Operate in one of these service fields:
* Accounting
* Actuarial science
* Architecture
* Consulting
* Engineering
* Health
* Law
* The performing arts
* Meet the gross receipts threshold specified in the tax rules (the rule includes a $5 million threshold as applied to recent tax years).

How the method works

Under NAE, a taxpayer estimates, using historical experience and formulas permitted by the tax regulations, the portion of billed revenue that will not be collected and does not accrue that portion as income. This differs from recognizing all billed revenue and later writing off specific uncollectible accounts.

The tax regulations (see IRC section 448(d)(5) and related guidance) describe acceptable formulas and procedures for determining uncollectible portions. Taxpayers may:
* Adopt an approved safe‑harbor formula, or
* Seek IRS consent to adopt a different formula that more accurately reflects their experience.

Safe harbor guidance

In guidance issued by the IRS, a safe-harbor approach was described that allows taxpayers using NAE to compute uncollectible revenue by applying a factor to the allowance for doubtful accounts as shown on applicable financial statements (an example safe‑harbor factor of 95% has been discussed in IRS guidance). Taxpayers should review current IRS guidance and consult advisors when applying a safe harbor.

Accounting and tax considerations

• NAE is available only to accrual-basis taxpayers.
• The matching principle requires expenses (including bad debt expense) be recognized in the same period as the related revenue. For financial reporting under GAAP, bad debts are typically accounted for using an allowance method in the period of the sale.
• For tax purposes, if NAE is not used or not permitted, businesses generally claim bad debts using the specific charge-off method.

Practical notes

• NAE can simplify recognition of uncollectible revenue for eligible small service providers whose historical experience supports a predictable level of bad debts.
• Because rules and safe‑harbor provisions can change, taxpayers should review the current IRS guidance and consider professional tax advice before adopting or changing an NAE method.

Sources

• Internal Revenue Service — Publication 535: Business Expenses (see discussion of bad debts and accounting methods)
• Internal Revenue Code section 448(d)(5) and related IRS guidance on accounting methods and nonaccrual experience methods