What is Constructive Receipt and How Does It Affect My Cash-Based Business?
Accounting has always had, historically, two methods of bookkeeping – Cash and Accrual. That being said, the IRS also defines Cash Modified as an accounting method, but that is a discussion for another day.
Accrual-based businesses report income and expenses according to GAAP, or Generally Accepted Accounting Principles. There are certain guidelines on when a business should use accrual-based bookkeeping, such as when inventory will be kept on hand or when you are above a certain revenue threshold, but many small businesses use a cash-based method instead.
Quick example: Charlie provided services over the course of December to a client. Revenue was technically earned by Charlie doing those services in December. Charlie invoiced his client December 31. His client paid the bill on January 10th of the next year.
Most accrual-based systems will time the revenue recognition in December, when the revenue was earned. However, a cash-based system will credit this revenue in January, when it was paid, or exchanged hands.
Let’s disseminate this a little further. Charlie receives the check on December 12th. Charlie is busy, so he leaves the check on his desk, and does not enter it into his accounting system.
Constructive receipt would dictate that Charlie had those funds on December 12th. He had the check in hand, unencumbered, and could spend it however he wanted. He chose not to deposit it, but that was his choice. According to the IRS’ definition of constructive receipt, those funds were available and taxable on December 12th.
What did Charlie miss? Charlie should receive the payment in his accounting system, such as QuickBooks Online, when it is received. If you receive the check, and deposit it to the Undeposited Funds account, that satisfies constructive receipt. Here’s a screenshot depicting a deposit to Undeposited Funds, which is how to report proper income at the proper time without depositing it to your bank account.
Let’s go a little deeper.
Say Charlie invoiced for November, received the check in December, and was on Christmas vacation, so didn’t deposit it until January. When should he report this income to the IRS and in his books according to constructive receipt?
For those of you smart cookies following along, I think you know already – December. The funds were in his possession and unencumbered in December, therefore the funds should be reported on a cash basis system in December, not January, via a customer payment and deposit to the holding account, Undeposited Funds. If Charlie just does a deposit in January, technically he is reporting this income in the wrong period. For more information, feel free to check out Constructive Receipt: What is it? (thebalancesmb.com).
We frequently get these timing questions at year end. Hopefully this overview of constructive receipt will help you to determine the correct timing of your deposits this year.
An accrual-based accounting system will treat both of these scenarios the same and is not subject to the rules of constructive receipt, and it will time the revenue recognition in the proper month for this scenario. Cash-based businesses will need to pay closer attention to their treatment of these deposits, and bank feeds may not adequately account for these receipts since they have not reflected in your bank yet.
If you have questions about how to do your books, or would like to discuss how we can help, please contact us using the form below, or book a session on our Calendly. Of course, if you are in a hurry, you can always call 980.210.6946 and we will be happy to help!
