Direct write-off method

What is the direct write-off method?

Direct Write off method is a way of recording bad debts. This is one of the two methods of
recording bad debts. Another accounting method of recording bad debt is the allowance
method.

An accounts receivable account is written off from the financial statements only when it is
considered uncollectible. This is an unfortunate event that a lot of small business owners have
to deal with.

While accounting for bad debts under the Direct Write off method, Accounts Receivable is
credited and the same amount is debited as the bad debts expense in the income statement.

Bad debts in business generally occur in a situation where the business has a credit sale.

How to use the direct write-off method?

Once the doubtful accounts receivable are considered uncollectible, they are recorded through
the direct write-off method to ensure that the records are accurate.

To record the bad debts expense, the company starts with identifying the uncollectible accounts.
Then it credits accounts receivable and debits bad debts expense. The bad debts are usually
the amount of the accounts receivable.

Let’s understand this with the help of an example. There is a company of a

semi-conductor parts shop that sells parts to customers on credit. Let’s say
that the business fulfills an order of $20,000 worth of parts. Even after
reaching the customer several times, it does not show any certainty of paying
for the product.

The shop marks the bad debt in its books by moving the uncollectible amount
out of accounts receivables, and into a bad debt account. For example

Account Debit Credit

 Bad Debt $20,000

Accounts Receivable $20,000

However, if the customer plans at paying back the product the accounting
transaction can be reversed by the company. Here is the entry of reversal:

Account Debit Credit

Bad Debt $20,000

Accounts Receivable $20,000

The payment can be recorded as follows:

Account Debit Credit

Cash $20,000

Accounts Receivable $20,000

It's important to note that unpaid invoices are a part of the accounts receivable balance. This is
because an unpaid invoice is considered an asset and shall be debited in the bookkeeping.

The direct write-off method is required for U.S. income tax reporting. Bad debts can be
deducted from the total taxable income while filing the annual tax returns. The IRS requires
small businesses to use the direct write off method to calculate these deductions.
One should note that the direct-write off method is not consistent with the matching principles. In
the direct write-off method, a bad debt is reported in the business records only when it is written
off from the customer's account.

This process might take place long after the initial sale has taken place. Also, recording bad
debts through this method affects only the bottom line of income in the current period.

The Direct Write off Method vs. the Allowance Method

THE DIRECT WRITE-OFF METHOD
When a small business owner determines an accounts receivable as uncollectible, using the
direct write-off method they debit this in the Bad Debt expense and credit the Accounting
Receivable. This helps in reducing the revenue and accounts receivable from the financial
statements.

THE ALLOWANCE METHOD

Under this method, a company needs to consistently review it's businesses account and
estimate an amount that it won't be able to recover. This happens annually and an estimated
amount is debited to a Bad Debts Expense Account and credited to a contra account known as
an Allowance for Doubtful Accounts.

1. Both accounting methods are used to record the bad debt of the company and
credit accounts receivable, respectively.
The direct write off method doesn't consider a bad-debt expense until there is no
expectation of recovery. On the contrary, the allowance method estimates a bad debt
and records them in the same sales period.
2. The generally accepted accounting principles (GAAP) does not hold the direct
write-off method valid since it does not follow the matching principle.
This is because it records the expense and revenue in different periods. However, GAAP
validates the use of the allowance method to create financial statements.
3. This implies that publicly held companies can not follow the direct write off
method.
Public-held companies only follow the allowance method while financial reporting.
4. The direct write off method and allowance method record the bad debt in different
periods.
The direct write off method lets small business charge the bad debt expense account
when they believe they won't be able to recollect the invoice. While in the allowance
method, they are expected to estimate the amount annually.

Direct write-off method advantages

1. Less Complicated
The direct write off method is considered an easier way to record transactions. This is because
it requires just one journal entry directly when the bad debt is decided to be written off from the
accounts receivable.
2. Tax Calculation
The IRS allows a Company to write off your bad debts from their annual tax returns. However, it
requires an accurate amount of bad debt. Thus, one has to file the tax return only using the
direct write off method.

This also minimizes any chances of errors while calculating tax returns.

3. Fewer Chances of error

The allowance method requires you to estimate an amount and, in the direct write-off method,
an actual amount is accounted for.

This helps in avoiding any misstatement while recording the bad debts expenses.

Direct write-off method disadvantages

Though the direct write-off method can be helpful for businesses, it also has many drawbacks.
Here are some disadvantages of using the direct write-off method:

1. Doesn't follow the matching principle

According to the matching principle, expenses are required to report expenses in the
same period which they incurred.
However, the direct write-off method doesn't realise bad expenses in the same
accounting period as the sales. Thus it doesn't validate the matching principle.
For example, if the company sells it's product in January, the company might have not
realised bad debts until March. A direct write-off happens in a different year than when
the sale is made.
2. Inaccurate Balance sheet calculation
In the direct write-off method, when customers owe the company it is directly accounted
for in the accounts receivables. However, if they are uncollectible accounts receivable, it
gives a false image of accounts receivables.

The direct write off method and GAAP

The GAAP doesn't validate the direct write-off method.

As per GAAP, it is mandatory to match the revenue with expenses in the same accounting
period. But with the direct write off method, the expense might be recorded in a different
accounting period than the sales period.

This implies that GAAP principles are not complied with by the direct write-off method. And thus
GAAP only allows the allowance method must be used when producing financial statements.

Why is the direct write-off method not used in the

accounting profession?
The direct-write off method is not validated by the GAAP.

Also, the direct-write off method does not record expenses in the same year as revenue. This
creates a false hype in the sales, for a short time. That is until the accounting is not done for the
expenses. Thus, in the accounting profession, the direct write-off method is avoided.

The Bottom Line

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