The direct write off method involves charging bad debts to expense only when individual invoices have been identified as uncollectible. Continuing our examination of the balance sheet method, assume that BWW’s end-of-year accounts receivable balance totaled $324,850. This entry assumes a zero balance in Allowance for Doubtful Accounts from the prior period.
The Direct Write off Method vs. the Allowance Method
Note that allowance for doubtful accounts reduces the overall accounts receivable account, not a specific accounts receivable assigned to a customer. Because it is an estimation, it means the exact account that is (or will become) uncollectible is not yet known. The journal entry for the Bad Debt Expense increases (debit) the expense’s balance, and the Allowance for Doubtful Accounts increases (credit) the balance in the Allowance. The allowance for doubtful accounts is a contra asset account and is subtracted from Accounts Receivable to determine the Net Realizable Value of the Accounts Receivable account on the balance sheet.
It violates GAAP
Accounts Receivable would be debited, and the Bad Debt Expense account would be reduced. While it’s not recommended for regular use, if your business seldom has bad debt, it can be a quick, convenient way to remove bad debt from your books. The direct write-off method can be a useful option for small businesses infrequently dealing with bad debt or if the uncollectibles are for a small amount. The receivable line item in the balance sheet tends to be lower under the allowance method, since a reserve is being netted against the receivable amount. Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries.
Tax reduction
The direct write-off method doesn’t adhere to the expense matching principle—an expense must be recognized during the same period that the revenue is brought in. As a result, the direct write-off method violates the generally accepted accounting principles (GAAP). To keep the business’s books accurate, the direct write-off method debits a bad debt account for the uncollectible amount and credits that same amount to accounts receivable. As of January 1, 2018, GAAP requires a change in how health-care entities record bad debt expense. Before this change, these entities would record revenues for billed services, even if they did not expect to collect any payment from the patient. GAAP mandates that expenses be matched with revenue during the same accounting period.
The allowance method requires a small business to estimate at the end of the year how much bad debt they have, while the direct write off method lets owners write off bad debt whenever they decide a customer won’t pay an invoice. As a result, although the IRS allows businesses to use the direct write off method for tax purposes, GAAP requires the allowance method for financial statements. New business owners may find the percentage of sales method more difficult to use as historic data is needed in order to estimate bad debt totals for the upcoming year. This journal entry eliminates the $500 balance in accounts receivable while creating an account for bad debt. The balance of the Allowance for Bad Debt account is subtracted from your revenue account to reduce the revenue earned. At this point, the $500 would be considered uncollectible, so Wayne needs to remove it from his accounts receivable account.
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By far the easiest write-off method, the direct write-off method should only be used for occasional bad debt write-offs. If Wayne allows this entry to remain on his books, his accounts receivable balance will be overstated by $500, since Wayne knows that it’s not collectible. When a specific customer has been identified as an uncollectible account, the following journal entry would occur. As you’ve learned, the delayed recognition of bad debt violates GAAP, specifically the matching principle. Therefore, the direct write-off method is not used for publicly traded company reporting; the allowance method is used instead. One issue that immediately crops up when it comes to this method is that of direct write off method GAAP compliance.
Often this occurs many months after the credit sale was made and is done with an entry that debits Bad Debts Expense and credits Accounts Receivable. The final point relates to companies with very little exposure to the possibility of bad debts, typically, entities that rarely offer credit to its customers. Assuming that credit is not a significant component of its sales, these sellers can also use the direct write-off method. The companies that qualify for this exemption, however, are typically small and not major participants in the credit market.
You may notice that all three methods use the same accounts for the adjusting entry; only the method changes the financial outcome. Also note that it is a requirement that the estimation method be disclosed in the notes of financial statements so stakeholders can make informed decisions. For the taxpayer, this means that if a company sells an item on credit in October 2018 and determines that it is uncollectible in June 2019, it must show the effects of the bad debt when it files its 2019 tax return. This application probably violates the matching principle, but if the IRS did not have this policy, there would typically be a significant amount of manipulation on company tax returns.
But, under the direct write off method, the loss may be recorded in a different accounting period than when the original invoice was posted. The business is left out of pocket with “bad debt” to balance in the books. The direct write off method offers a way to deal with this for accounting purposes, but it comes with some pros and cons. Write-offs affect both balance sheet and income statement accounts on your financial statement, so it’s important to be accurate when handling bad debt write-offs. While the direct write-off method is the easiest way to eliminate bad debt, it should be used infrequently and with caution.
You are considering switching to the balance sheet aging of receivables method. This would split accounts receivable into three past- due categories and assign a percentage to each group. For example, when companies account for bad debt expenses in their financial statements, they will use an accrual-based method; however, they are required to use the direct write-off method on their income tax returns. This variance in treatment addresses taxpayers’ potential to manipulate when a bad debt is recognized.
For example, a category might consist of accounts receivable that is 0–30 days past due and is assigned an uncollectible percentage of 6%. Another category might be 31–60 days past due and is assigned an uncollectible percentage of 15%. All categories of estimated uncollectible amounts are summed to get a total estimated uncollectible balance. That total is reported in Bad Debt Expense and Allowance for Doubtful Accounts, if there is no carryover balance from a prior period. If there is a carryover balance, that must be considered before recording Bad Debt Expense. The balance sheet aging of receivables method is more complicated than the other two methods, but it tends to produce more accurate results.
The direct write off method is a way businesses account for debt can’t be collected from clients, where the Bad Debts Expense account is debited and Accounts Receivable is credited. As a direct write off method example, imagine that a business submits an invoice for $500 to a client, but months have gone by and the client still hasn’t paid. At some point the business might decide that this debt will never be paid, so it would debit the Bad Debts Expense account for $500, and apply this same $500 as a credit to Accounts Receivable. The direct write-off method lets you charge bad debts directly to an expense such as the Allowance for Bad Debt account used in the journal entries above.
The alternative to the direct write off method is to create a provision for bad debts in the same period that you recognize revenue, which is based upon an estimate of what bad debts will be. This approach matches revenues with expenses, so that all aspects of a sale are included within a single reporting period. Conversely, the direct write-off method might involve a delay of several months between the initial sale and a charge to bad debt expense, which does not provide a complete view of a transaction within one reporting period.
This creates a lengthy delay between revenue recognition and the recognition of expenses that are directly related to that revenue. Thus, the profit in the initial month is overstated, while profit is understated in the month when the bad debts are finally charged to expense. With this method, accounts receivable is organized into categories by length of time outstanding, and an uncollectible percentage is assigned to each category.
- In this example, the $85,200 total is the net realizable value, or the amount of accounts anticipated to be collected.
- It may be obvious intuitively, but, by definition, a cash sale cannot become a bad debt, assuming that the cash payment did not entail counterfeit currency.
- This journal entry takes into account a debit balance of $20,000 and adds the prior period’s balance to the estimated balance of $58,097 in the current period.
Thus, virtually all of the remaining bad debt expense material discussed here will be based on an allowance method that uses accrual accounting, the matching principle, and the revenue recognition rules under GAAP. Then all of the category estimates are added together to get one total estimated uncollectible balance for the period. The entry for bad debt would be as follows, if there was no carryover balance from the prior period. The direct write-off method delays recognition of bad debt until the specific customer accounts receivable is identified.
BWW estimates 15% of its overall accounts receivable will result in bad debt. As the accountant for a large publicly traded food company, you are considering whether or not you need to change your bad debt estimation method. You currently use the income statement method to estimate bad debt at 4.5% of credit sales.
