Using the direct write-off method is an effective way for your business to recognize any bad debt. Bad debt refers to debt that customers owe for a good or service but won’t be paying back. In other words, it’s money they need to pay for a sale or service that they won’t be paying and the company won’t be receiving. Another way to refer to this is uncollectible receivables. Using the direct write-off method can help your business easily manage bad debt if you rarely get uncollected payments. In this article, you’ll learn how to use the direct write-off method for your business and the potential advantages and disadvantages of a direct write-off.
In this article, we’ll cover:
- What is the direct write-off method?
- The Direct Write-off Method and GAAP
- The Direct Write-off Method vs. the Allowance Method
- Advantages of the direct write-off method
- Disadvantages of the direct write-off method
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.
The Direct Write-off Method and GAAP
The direct write-off method does not comply with the generally accepted accounting principles (GAAP), according to the Houston Chronicle.
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.
This means that when the loss is reported as an expense in the books, it’s being stacked up on the income statement against the revenue that’s unrelated to that project. Now total revenue isn’t correct in either the period the invoice was recorded or when the bad debt was expensed.
This distortion goes against GAAP principles as the balance sheet will report more revenue than was generated. This is why GAAP doesn’t allow the direct write-off method for financial reporting. The allowance method must be used when producing financial statements.
The Direct Write-off Method vs. the Allowance Method
Under the direct write-off method, bad debt is charged to expense as soon as it is apparent that an invoice will not be paid. Under the allowance method, an estimate of the future amount of bad debt is charged to a reserve account as soon as a sale is made. This results in the following differences between the two methods:
- Timing. Bad debt expense recognition is delayed under the direct write-off method, while the recognition is immediate under the allowance method. This results in higher initial profits under the direct write-off method.
- Accuracy. The exact amount of the bad debt expense is known under the direct write-off method since a specific invoice is being written off, while only an estimate is being charged off under the allowance method.
- Receivable line item. The receivable line item in the balance sheet tends to be lower under the allowance method since a reserve is being netted against the receivable amount.
Advantages of the direct write-off method
When owning a business, it’s important to understand not only the direct write-off method but its advantages, as well. Here are some of the advantages of using this method:
The direct write-off method is considered an easy way to deal with bad debts because you only need to make two transactions—one to the bad debts expenses account and the other to accounts receivable for the amount the customer owes. In contrast, the allowance method requires you to report bad debt expenses every fiscal year.
2. Tax write-off
Companies with bad debt can write it off on their annual tax returns. This is because although the direct write-off method doesn’t follow the Generally Accepted Accounting Principles (GAAP), the IRS requires companies to use this method for their tax returns. In other words, bad debt expenses can be written off from a company’s taxable income on their tax return. The inaccuracy of the allowance method can’t be utilized under these circumstances because the IRS needs an accurate way to calculate a deduction.
3. It’s based on an actual amount
Whereas management estimates the write-off in the allowance method, the direct write-off method is based on an actual amount. The direct write-off method avoids any errors in this regard and also reduces the risk of overstating or understanding any expenses.
Disadvantages of the direct write-off method
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. Violates the matching principle
As mentioned above, the use of the direct write-off method violates the matching principle. This is because according to the matching principle, expenses need to be reported in the same period in which they were incurred. With the direct write-off method, however, bad expenses might not be realized to be bad expenses until the following period. For example, if you made a sale at the end of one accounting period ending in December, you might not realize the bad debts until the beginning of March. A direct write-off often happens in a different year than when the sale was made, or in other words, the revenue was recorded by your business.
2. Balance sheet inaccuracy
Another disadvantage of the direct write-off method regards the balance sheet. Since using the direct write-off method means crediting accounts receivable, it gives a false sense of a company’s accounts receivable.
3. Violates GAAP
Using the direct write-off method also violates the GAAP because of how it records things on the balance sheet. Financial statements are not giving an accurate portrayal of how the business is doing financially.
4. Overstates accounts receivable
Using the direct write-off method, your business reports the full amount of what customers owe when a credit sale is made. This is referred to as accounts receivable. But if your company were to have uncollectible accounts receivable, the amount in accounts receivable would be too high.
You own a car auto shop and install a new engine in a customer’s car for $3,000. After attempting to contact the customer for the invoice of $3,000, you have yet to hear back for months. After this time, you deem it uncollectible and record it as a bad debt. In this case, the accounts receivable account is reduced by $3,000 and is recorded as a bad debt expense.