The Direct Write off Method: How to Handle Bad Debts in the Books

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.

• Total revenue is now incorrect in both the period in which the invoice was recorded and the period in which the bad debt was expensed.
• Because of how it records things on the balance sheet, using the direct write-off method also violates GAAP.
• 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.
• It’s credited to a counter account called an allowance for questionable accounts.
• Companies account for uncollectible accounts using two methods – the direct write-off method and the allowance method.

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. In the case of the allowance for doubtful accounts, it is a contra account that is used to reduce the Controlling account, Accounts Receivable. The direct write-off method delays recognition of bad debt until the specific customer accounts receivable is identified.

Unit 10: Receivables

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. At the end of an accounting period, the Allowance for Doubtful Accounts reduces the Accounts Receivable to produce Net Accounts Receivable. Note that allowance for doubtful accounts reduces the overall accounts receivable account, not a specific accounts receivable assigned to a customer.

• As a one-time occurrence, you can deal with managing the inaccuracy of your financial statements, and it is faster and easier to do.
• GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices.
• The direct write-off method recognizes bad accounts as an expense at the point when judged to be uncollectible and is the required method for federal income tax purposes.

Sometimes when you’re a small business owner, freelancer, or sole proprietor, it can be hard to find the time to keep up with all of your bookkeeping. But tracking how much money is coming in and going out of your business is crucial for making smart decisions. Bad Debt Expense increases (debit) as does Allowance for Doubtful Accounts (credit) for $58,097.

Pro: It’s simple

You must credit the accounts receivable and debit the bad debts expense to write it off. The allowance method records an estimate of bad debt expense in the same accounting period as the sale. It often takes months for companies to identify specific uncollectible accounts. The allowance method follows the matching principle, which states revenues need to be matched with the expenses incurred in that same accounting period. The allowance method is used to allow for bad debts on the income statements.

Direct Write-off Method FAQs

When the account defaults for nonpayment on December 1, the company would record the following journal entry to recognize 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. 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. Hence, the company won’t be showing the true and fair view of its
financial statements if the direct write-off method was used since it violates
the basic principles of accounting.

What is the Direct Write-off Method?

This method can be regarded as a fair accounting method if the amount written off is insignificant. This is because doing so has little impact on an entity’s reported financial results and hence does not distort the decisions of a person reading the company’s financial statements. When the company considers an account to be completely uncollectible, it makes a debit to allowance for doubtful accounts and a credit to accounts receivable. Companies only have to make two transactions for the amount of the customer’s bad debt. Another advantage is that companies can write off their bad debt on their annual tax returns.

Balance Sheet Method for Calculating Bad Debt Expenses

It’s obviously simpler for small business owners who don’t have accounting experience. It also deals with real losses rather than preliminary predictions, how to calculate after-tax salvage value when the project ends which might be less confusing. This deviation violates GAAP rules since the balance sheet will show greater revenue than was earned.

GAAP and The Direct Write Off Method

Additionally, if you have little experience with bad debt, any estimates you make may end up very inaccurate. With the allowance method, since you have already planned for a portion of your Accounts Receivables to turn into bad debt, you have a more realistic view of how your business is doing. The allowance method, while following the GAAP, is based on an estimate at the end of a financial year. One way your business can realize any bad debt (that is, uncollected receivables) is through the direct write-off method. A company’s accounts receivable are considered to be a type of asset, and as such can be pledged as collateral for a loan. Asset-based lenders will often lend a company an amount equal to 80% of the value of its accounts receivable.

The allowance method is the standard technique for recording uncollectible accounts for financial accounting objectives and represents the accrual foundation of accounting. 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.