If you’re wondering which method is best for your small business, speak with a professional for insights into your specific situation. Beginning bookkeepers in particular will appreciate the ease of the direct write-off method, since it only requires a single journal entry. If an old debt is paid, the journal entry can simply be reversed https://www.kelleysbookkeeping.com/the-ugly-truth-about-lying-on-your-taxes/ and the payment posted to the customer’s account. 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 direct write-off method waits until an amount is determined to be uncollectible before identifying it in the books as bad debt. Reporting revenue and expenses in different periods can make it difficult to pair sales and expenses and assets and net income can be overstated. 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). If you consistently have uncollectible accounts, use the allowance method for writing off bad debt, as it follows GAAP rules while keeping financial statements accurate. Using the allowance method can also help you prepare more accurate financial projections for your business.
There are several advantages to using the direct write-off method, which make it an especially appealing choice for smaller organizations, especially those with relatively unskilled accounting personnel. First, it is quite simple – just charge a receivable to bad debt expense, and you are done. Second, a bad debt charge-off is easy to prove, since it is based on an actual unpaid invoice; this is not the case with the allowance method, where an estimate of possible bad debts is being charged to expense. Under the direct write-off method, bad debts expense is first reported on a company’s income statement when a customer’s account is actually written off. 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 two accounting methods used to handle bad debt are the direct write-off method and the allowance method.
Under the allowance method, a company needs to review their accounts receivable (unpaid invoices) and estimate what amount they won’t be able to collect. This estimated amount is then debited from the account Bad Debts Expense and credited to a contra account called Allowance for Doubtful Accounts, according to the Houston Chronicle. 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. If you’re a small business owner who doesn’t regularly deal with bad debt, the direct write-off method might be simpler. But the allowance method is more commonly preferred and often used by larger companies and businesses frequently handling receivables.
THE DIRECT WRITE OFF METHOD
By far the easiest write-off method, the direct write-off method should only be used for occasional bad debt write-offs. No matter how carefully and thoroughly you screen your customers or manage your accounts receivable, you will end up with bad debt. Bad debt is the money that a customer or customers owe that you don’t believe you will be able to collect. But, the write off method allows revenue to be expensed whenever a business decides an invoice won’t be paid. This makes a company appear more profitable, at least in the short term, than it really is. 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.
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. Therefore, the allowance method is considered the more acceptable accounting method. The direct write off method involves charging bad debts to expense only when individual invoices have been identified as uncollectible.
GAAP mandates that expenses be matched with revenue during the same accounting period. But, under the direct write off method, the loss may be recorded in a different accounting period than when the original invoice was posted. When using this accounting method, a business will wait until a debt is deemed unable to be collected before identifying the transaction in the books as bad debt. At this point, the $500 would be considered uncollectible, so Wayne needs to remove it from his accounts receivable account. If he does not write the bad debt off, it will stay as an open receivable item, artificially inflating his accounts receivable balance.
What is the Direct Write Off Method?
Although only publicly held companies must abide by GAAP rules, it is still worth considering the implications of knowingly violating GAAP. Because write-offs frequently occur in a different year than the original transaction, it violates the matching principle; one of 10 GAAP rules. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.
For example, a company may recognize $1 million in sales in one period, and then wait three or four months to collect all of the related accounts receivable, before finally charging some bad debts off to expense. 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. The method does not involve a reduction in the amount of recorded sales, only the increase of the bad debt expense. For example, a business records a sale on credit of $10,000, and records it with a debit to the accounts receivable account and a credit to the sales account.
- The method does not involve a reduction in the amount of recorded sales, only the increase of the bad debt expense.
- In fact, The IRS requires businesses with bad debt to use the direct write-off method for their return, even though it does not comply with Generally Accepted Accounting Principles (GAAP).
- The direct write off method is simpler than the allowance method as it takes care of uncollectible accounts with a single journal entry.
- By far the easiest write-off method, the direct write-off method should only be used for occasional bad debt write-offs.
For instance, a business may be aware of uncollectible debts, but may delay in writing them off, resulting in artificially inflated revenues. The direct write-off method can also wreak havoc on your profit and loss statement and perceived profitability, both before and after the bad debt has been written off. For example, Wayne spends months trying to collect payment on a $500 invoice from one of his customers. The direct write-off method does not comply with the generally accepted accounting principles (GAAP), according to the Houston Chronicle. 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 Direct Write-Off Method: Should You Use It In Your Business?
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. The direct write-off method is a simple process, where you would record a journal entry to debit your bad debt account for the bad debt and credit your accounts receivable account for the same amount. Apparently the Internal Revenue Service does not want a company reducing its taxable income by anticipating an estimated amount of bad debts expense (which is what happens when using the allowance method). The direct write off method violates GAAP, the generally accepted accounting principles. GAAP says that all recorded revenue costs must be expensed in the same accounting period.
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