What happens when a customer doesn’t pay for products or services? 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.
What is the direct write off method?
To better understand the answer to “what is the direct write off method,” it’s first important to look at the concept of “bad debt”. Bad debt refers to any amount owed by a customer that will not be paid. The direct write off method of accounting for bad debts allows businesses to reconcile these amounts in financial statements.
To apply the direct write off method, the business records the debt in two accounts:
Bad Debts Expenses as a debit
Accounts Receivable as a credit
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 IRS allows bad debts to be written off as a deduction from total taxable income, so it’s important to keep track of these unpaid invoices in one way or another. It’s also important to note that unpaid invoices are categorized as assets, which are debited in accounting.
In the direct write off method example above, what happens if the client does end up paying later on? Both charges would be reversed. Accounts Receivable would be debited, and the Bad Debt Expense account would be reduced.
Direct write off method GAAP compliance
One issue that immediately crops up when it comes to this method is that of direct write off method GAAP compliance. The direct write off method doesn’t comply with the GAAP, or generally accepted accounting principles.
GAAP states that expenses and revenue must be matched within the same accounting period. However, the direct write off method allows losses to be recorded in different periods from the original invoice dates. This means that reported losses could appear on the income statement against unrelated revenue, which distorts the balance sheet. It will report more revenue than might have actually been generated.
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.
Direct write off method vs. the allowance method
The allowance method offers an alternative to the direct write off method of accounting for bad debts. With the allowance method, the business can estimate its bad debt at the end of the financial year. Rather than writing off bad debt as unpaid invoices come in, the amount is tallied up only at the end of the accounting year.
The estimated amount is debited from the Bad Debts Expense and credited to an Allowance for Doubtful Accounts to maintain balance.
Direct write off method advantages
There are several advantages to using the direct write off method:
Straightforward procedure: The direct write off method offers a simple way to deal with unpaid debts. You only need to list two transactions for each unpaid invoice, with greater flexibility on timings.
Tax deductions: You can write off your bad debt on annual tax returns, according to the IRS. By contrast, the IRS won’t accept bad debts written off using the allowance method, because it uses estimates rather than precise figures.
Precision: Because it’s based on factual amounts gleaned directly from invoices, the direct write off method prevents errors in your financial reporting.
Direct write off method disadvantages
At the same time, there are some disadvantages to be aware of:
It goes against the matching principle: According to the matching principle in accounting, expenses must be reported in the same period that they were incurred. Bad expenses might not be recognized until later on with the direct write-off method, which would lead to a mismatch.
It can cause inaccuracy: The mismatch in timings mentioned above could also cause an inaccuracy in your business’s balance sheet. Crediting the accounts receivable could overstate profit.
It causes GAAP violations: The GAAP doesn’t allow use of the direct write off method because of these inaccuracies. Financial statements might not accurately reflect a business’s true financial standing.
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If you sell on credit, you’ll likely have to deal with bad debt. Should you use the direct write-off method to deal with those bad debts or is there a better way?The direct write-off method is one of the easier ways to manage bad debt. 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.
However, you’ll find a lot of disadvantages to using the direct write-off method, which will be covered in more detail later.
Overview: What is the direct write-off method?
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.
Your small business bookkeeper or accountant needs to manage bad debt properly. If you don’t sell to your customers on credit, you won’t have any bad debt, but it’s likely that you’ll also have a much smaller customer base.
If you offer credit terms to your customers, you’ll have at least a few bad debt accounts. While stringent customer screening can help to reduce bad debt, it won’t eliminate it.
You can use two methods to manage bad debt. One method, the direct write-off method, should only be used occasionally, while the allowance method requires you estimate bad debt you expect before it even occurs.
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.
For example, Wayne spends months trying to collect payment on a $500 invoice from one of his customers. However, all of the invoices and letters he has mailed have been returned.
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.
The following journal entry is how the initial sale was recorded:
| 1-1-2020 | Accounts Receivable | $500 | |
| 1-1-2020 | Sales Revenue | $500 |
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 write-off journal entry to eliminate the $500 using the direct write-off method is:
| 5-15-2020 | Allowance for Bad Debt | $500 | |
| 5-15-2020 | Accounts Receivable | $500 |
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.
If Wayne’s customer eventually pays the bill in September, he would simply reverse the entry above, and post the payment:
| 5-15-2020 | Accounts Receivable | $500 | |
| 5-15-2020 | Allowance for Bad Debt | $500 |
You can then post the payment with the following journal entry:
| 5-15-2020 | Cash | $500 | |
| 5-15-2020 | Accounts Receivable | $500 |
Direct write-off method vs. allowance method: What's the difference?
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. By far the easiest write-off method, the direct write-off method should only be used for occasional bad debt write-offs.
If you have more than the occasional bad debt, use the allowance for bad debt method, which uses an estimate of future bad debt. The allowance method includes three different methods that can be used to estimate bad debt:
- Percentage of Sales Method: This method uses a percentage of prior year sales in order to estimate the bad debt. For instance, if you had sales of $75,000 for the year, and collected $68,000, you could estimate that bad debt for the upcoming year could be set at 10% or $7,500, very close to the amount that you didn’t collect last year.
- Aging of Receivables Method: The aging of receivables method allows you to estimate a percentage of your accounts receivable aging as uncollectible, with the premise that an account over 90 days old will have a much higher rate of uncollectibility. This method is probably not useful if you don’t have a lot of bad debt.
- Percentage of Receivables Method: The percentage of receivables method calculates bad debt based on the current balance in accounts receivable, making an adjustment to accurately account for current bad debt.
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.
Advantages of using the direct write-off method
The direct write-off method has advantages and disadvantages. Some of the advantages include:
1. Simplicity
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 and the payment posted to the customer’s account.
2. Tax reduction
A company that ends the year with bad debt can write that bad debt off on their tax return. 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).
3. It writes off the true balance, not an estimate
The direct write-off method allows you to write off the exact bad debt, not an estimate, meaning that you don’t have to worry about underestimating or overestimating uncollectible accounts.
Drawbacks of the direct write-off method
While great for the occasional bad debt write-off, the direct write-off method also has some serious disadvantages. Some include:
1. It violates GAAP
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.
The matching principle states that any transaction that affects one account needs to affect another account during that same period.
2. It can overstate receivables
While this is not an issue for a business that uses the direct write-off method occasionally, if you regularly employ this method, your accounts receivable balance may be overstated, due to the uncollectible balances still on the books.
3. Inaccuracy in reporting profits
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.
Use the direct write-off method with caution
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.
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.
If you’re looking for accounting software that can help you manage the entire accounts receivable process, check out The Ascent’s accounting software reviews.