The direct write-off method is one of two ways to account for bad debt. When customers refuse or are unable to pay money owed to you for credit sales, it's essential to keep track of this accurately for financial reporting purposes. It helps you make accurate tax claims for bad debt with the government and can be part of the process of keeping accurate track of money owed to you and uncollectible debts.
The direct method treats a bad account as an expense when it's clear that you can't collect it and is required for federal income tax purposes. The allowance method is the other way to account for bad debt and is preferred by professional accountants as the more accurate way to handle uncollectible receivables.
What Is the Difference Between the Direct Write-Off and Allowance Method?
For businesses, the direct write-off is a simpler way to handle bad debt, and it must be used when dealing with unpaid accounts in federal taxes. Since the direct write-off method can sometimes give the wrong impression of how much money was made or lost in a financial period, professional accountants prefer the allowance method, which is in keeping with their accrual practices.
Understanding the Direct Write-Off Method
Using the direct write-off method of accounting, a business owner can debit the bad debts expense account and credit accounts receivable. Say a digital marketing firm charges a client $7,000 for a campaign, and the client decides not to pay or can't pay. The marketing firm would debit the bad debts expense for this amount and credit accounts receivable for the $7,000.
The amount in accounts receivable is considered an asset. But it could distort the company's financial picture because it may not equal what is actually collected for the customer's account (if the customer later doesn't pay their invoice), which is why accountants don't like the method.
Understanding the Allowance Method
While the direct write-off method isn't in compliance with generally accepted accounting principles (GAAP), the allowance method is. Under this method, a company at the end of its business year needs to review its accounts receivable and estimate how much of the total figure it thinks it won't be able to collect.
The estimated amount is then debited from the bad debts expense and credited to the contra-asset account, allowance for doubtful accounts (also known as allowance for uncollectible accounts or allowance for bad debts). In this case, accounts receivable becomes a more accurate reflection of how much the company really expects to collect for its amount of bad debt.
So, in the example above, the $7,000 owed to the digital marketing firm would be debited from the bad debts expense account and credited to the contra-asset account, allowance for doubtful accounts. Because this is done in the same accounting period as the corresponding credit sale, it better conforms to accepted accounting practices.
Why Is the Allowance Method Preferred Over the Direct Write-Off?
For financial accounting purposes, the allowance method is preferred over the direct write-off method because it more accurately conveys financial information. Under the direct write-off method, a company may move an amount from its bad debts expense account to accounts receivable in one financial period, only to find it's an uncollectible amount in the next, meaning it being recorded as an asset in the first financial period was a mistake.
With the allowance method, a company at the end of an accounting period records an adjusting entry estimating how many uncollected debts it will have, involving the bad debts expense account and the contra-asset account, allowance for doubtful accounts. So, an uncollected account is debited from the bad debts expense account and credited to the allowance for doubtful accounts in the same accounting period as the original sale.
With this method, the income statement reports the bad debts expense nearer to the time of the sale, and the balance sheet gives a more accurate picture of which accounts receivable will actually turn into cash.
What Are the Benefits and Disadvantages of the Direct Write-Off Method?
In deciding which method to use to account for bad debt, you need to understand the benefits and disadvantages of the direct write-off method.
Benefits of the Direct Write-Off Method
The benefits of the direct write-off method include:
- Tax write-offs: Under the American tax system, bad debt can often be written off, reducing taxable income. The Internal Revenue Service (IRS) requires companies to use the direct write-off method in their returns because it is an exact method. The allowance method of estimating the amount of debt in an accounting period isn't permitted by the IRS.
- Ease of use: Simplicity is one of the hallmarks of the direct write-off method since you only need to make two transactions: putting the amount the customer owes in the bad debts expense account (debit) and accounts receivable (credit). However, this method assumes you'll collect the money owed, which is not always the case.
- Actual amounts: Since the direct write-off method uses actual amounts for bad expenses and accounts receivable, not an estimated amount for the entire financial period, it helps avoid errors and overstating or understanding expenses.
- Violates generally accepted accounting principles: GAAP principles require that expenses and revenue align in the same financial period. With the direct write-off method, a financial loss may be recorded in a different period than the associated revenue. When it does appear as a loss, it's matched with revenue with which it has no association. This could lead to misrepresentations of how a business is doing financially. The allowance method follows accounting matching principles.
- Balance sheet becomes unbalanced: The direct write-off method could lead to misrepresentation of how a business is doing financially in its balance sheet since the practice of crediting accounts receivable can give a false sense of the current assets.
- Accounts receivable inaccuracy: In this case, accounts receivable may be misleading or overstated. All the debts shown in the direct write-off method are considered collectible and, therefore, assets. But, in fact, some of the accounts may not be recoverable, so they inflate your assets for the period. The allowance method usually gives a more accurate view of the dollar value of accounts receivable, including only the assets deemed collectible.
Challenges With the Direct Write-Off Method
Some of the drawbacks of using the direct write-off method include:
- Violates generally accepted accounting principles: GAAP principles require that expenses and revenue align in the same financial period. With the direct write-off method, a financial loss may be recorded in a different period than the associated revenue. When it does appear as a loss, it’s matched with revenue with which it has no association. This could lead to misrepresentations of how a business is doing financially. The allowance method follows accounting matching principles.
- Balance sheet becomes unbalanced: The direct write-off method could lead to misrepresentation of how a business is doing financially in its balance sheet since the practice of crediting accounts receivable can give a false sense of the current assets.
- Accounts receivable inaccuracy: In this case, accounts receivable may be misleading or overstated. All the debts shown in the direct write-off method are considered collectible and, therefore, assets. But, in fact, some of the accounts may not be recoverable, so they inflate your assets for the period. The allowance method usually gives a more accurate view of the dollar value of accounts receivable, including only the assets deemed collectible.
What Does a Journal Entry Look Like for a Bad Debt Expense Using the Direct Write-Off Method?
When you use a software package, such as Skynova's accounting software, you can view your direct write-off figures as a journal entry in an easy-to-read chart for your financial statements. The direct write-off method reports bad debt expenses as they happen.
A bad expense would be recorded in accounts receivable in the year it occurs. So, if an engineer receives on credit a major software package from a developer for $1,200 in 2020, it would be recorded in a direct write-off chart, looking something like this:
| Date | Accounts/Explanation | Debit | Credit |
|---|---|---|---|
| 9-9-2020 | Bad Debts Expense Accounts Receivable |
$1,200 | $1,200 |
However, if the engineer goes bankrupt the next without paying for the software package, it becomes uncollected debt. That would overstate the bad debt expense for 2020 by $1,200 and understate for 2021 by the same amount. This, in turn, would give an unfair or incomplete financial picture for the software company for the two years since it violates the accounting principle of showing revenues and matching expenses for the same financial period.
Skynova Is Here to Help You Keep Accurate Accounting Records
Whether you use the direct write-off method or allowance method of keeping track of bad debt, Skynova's accounting software can help you keep accurate records that can mean all the difference in running your small business smoothly and in compliance with tax law.
Whether you have accounting or bookkeeping experience, our easy-to-use software records all your transactions automatically in the correct accounts. As well, all accounting data from the software's subledgers are transferred to the general ledger.
You can also turn to Skynova's full suite of online software modules to help with your small business needs, from invoicing to submitting professional retainers, credit notices, and work orders. Skynova gives you the means to resolve bad debt with good business practices.
Notice to the Reader
The content of this article is meant to be used as general information and help. It may not apply to your specific situation. It's wise to always consult with a professional accountant for guidance tailored to your particular needs.