How To Use the Direct Write-Off Method

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.

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.

Drawbacks of the direct write-off method

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.

To keep the business’s books accurate, the direct write-off method debits a bad debt account for the uncollectible amount and credits that same amount to accounts receivable. 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 https://www.online-accounting.net/tax-form-1120-about-form-1120-u-s-corporation/ base. Under the direct write off method, when a small business determines an invoice is uncollectible they can debit the Bad Debts Expense account and credit Accounts Receivable immediately. This eliminates the revenue recorded as well as the outstanding balance owed to the business in the books.

The Direct Write off Method vs. the Allowance Method

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. 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). 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.

While the direct write-off method doesn’t label a transaction as bad debt until it’s deemed uncollectible, the allowance method estimates ahead of time how much bad debt the business anticipates and records it in the sale period. The specific action used to write off an account receivable under this method with accounting software is to create a credit memo for the customer in question, which offsets the amount of the bad debt. Creating the credit memo creates a debit to a bad debt expense account and a credit to the accounts receivable account. Big businesses and companies that regularly deal with lots of receivables tend to use the allowance method for recording bad debt. The allowance method adheres to the GAAP and reports estimates of bad debt expenses within the same period as sales. With the direct write-off method, there is no contra asset account such as Allowance for Doubtful Accounts.

1. Big businesses and companies that regularly deal with lots of receivables tend to use the allowance method for recording bad debt.
2. 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.
3. 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.
4. The balance of the Allowance for Bad Debt account is subtracted from your revenue account to reduce the revenue earned.

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.

Terms Similar to the Direct Write Off Method

After two months, the customer is only able to pay $8,000 of the open balance, so the seller must write off $2,000. It does so with a $2,000 credit to the accounts receivable account and an offsetting debit to the bad debt expense account. Thus, the revenue amount remains the same, the remaining receivable is eliminated, and an expense is created in the amount of the bad debt.

It can overstate receivables

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 Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters. We’re firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers.The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team. However, you’ll find a lot of disadvantages to using the direct write-off method, which will be covered in more detail later.

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 biggest tax haven in u s south dakota says pandora papers investigation 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.

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 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. 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. Bad debts in business commonly come from credit sales to customers or products sold and services performed that have yet to be paid for.