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

December 16, 2024April 6, 2025 samBookkeeping

Organizations with robust data analytics and forecasting systems are better equipped to estimate future bad debts accurately, making the allowance method more feasible for them. On the other hand, businesses lacking such capabilities may find the direct write-off method more practical, despite its potential drawbacks in financial reporting accuracy. 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. The Direct Write-off method is a process of booking the unrecoverable part of receivables that are no longer collectible by removing that part from the books of accounts without prior booking for the provisions of bad debts expenses.

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Apparently the Internal Revenue Service does not want a company reducing its taxable income by anticipating an estimated amount of bad debts expense (which is what happens when using the allowance method). 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. The business is left out of pocket with “bad debt” to balance in the books.

Why is the allowance method typically preferred over the direct write-off method?

The marketing firm would debit the bad debts expense for this amount and credit accounts receivable for the $7,000. 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. 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. After two months, the customer is only able to pay $8,000 of the open balance, so the seller must write off $2,000.

Direct Write-Off Method Vs Allowance Method

The direct write off excel cash book method involves charging bad debts to expense only when individual invoices have been identified as uncollectible. 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. With the direct write-off method, there is no contra asset account such as Allowance for Doubtful Accounts. Therefore the entire balance in Accounts Receivable will be reported as a current asset on the company’s balance sheet. As a result, the balance sheet is likely to report an amount that is greater than the amount that will actually be collected.

THE DIRECT WRITE OFF METHOD

For instance, the matching principle isn’t really followed because the loss from this account is recognized several periods after the income was actually earned.
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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.
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.
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.

The direct sales anduse tax in california write off method doesn’t comply with the GAAP, or generally accepted accounting principles. An accounting firm prepares a company’s financial statements as per the laws in force and hands over the Financial Statements to its directors in return for a Remuneration of $ 5,000. The firm is taking regular follow-ups with the Company’s directors, to which the directors are not responding. The firm then debits the Bad Debts Expenses for $ 5,000 and credits the Accounts Receivables for $ 5,000. The firm partners decide to write off these receivables of $ 5,000 as Bad Debts are not recoverable. The direct write-off method is the simplest method to book and record the loss on account of uncollectible receivables, but it is not according to the accounting principles.

This shall give us a deeper understanding of the process and its intricacies.
Instead, the company sends an invoice along with the goods or after selling the product or providing a service.
The firm then debits the Bad Debts Expenses for $ 5,000 and credits the Accounts Receivables for $ 5,000.
The Coca-Cola Company (KO), like other U.S. publicly-held companies, files its financial statements in an annual filing called a Form 10-K with the Securities & Exchange Commission (SEC).
Using the direct write-off method, Natalie would debit the bad debts expenses account by $ 1,500 and credit the accounts receivable account with the same amount.
It estimates uncollectible accounts at the end of each accounting period, creating a reserve or allowance for doubtful accounts.

The allowance method follows GAAP matching principle since we estimate uncollectible accounts at the end of the year. We use this estimate to record Bad Debt Expense and to setup a reserve account called Allowance for Doubtful Accounts (also called Allowance for Uncollectible Accounts) based on previous experience with past due accounts. We can calculate this estimates based on Sales (income statement approach) for the year or based on Accounts Receivable balance at the time of the estimate (balance sheet approach).

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If Beth later receives the payment from the customer, she can reverse the write off journal entry by crediting bad debt and debiting accounts receivable. Beth can then record the receipt of the cash with a debit to cash and a credit to accounts receivable. Note that we are simply writing it off as bad debt expenses as we know that the client is not going to pay us and not using the allowance account. In addition, although the company writes off the debt, it does not mean that it forgives this debt.

The Direct Write-off Method only captures an expense when a company determines a debt to be uncollectible. Publicly traded companies are obligated to follow GAAP or IFRS, which endorse the allowance method. Private companies, while not strictly bound by these standards, may still opt for the allowance method if they seek to engage with investors or lenders who prefer GAAP-compliant financial statements. Additionally, the tax implications of each method may sway a company’s choice, as tax authorities may have specific regulations regarding the treatment of bad debts.

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. GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments. The how to make an invoice allowance method is the more generally accepted method due to the direct write-off method’s limitations.

What is Equity in Accounting and Finance?

Despite these advantages, this method is used only by companies with very low levels of receivables. It is not the preferred method under GAAP because it does not match up business debt expense to when it actually makes the sale, and revenue comes into play on the Profit and Loss Statement. In the direct write off method example above, what happens if the client does end up paying later on? Accounts Receivable would be debited, and the Bad Debt Expense account would be reduced. 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. After determining a debt to be uncollectible, businesses can use the direct write-off method to ensure records are accurate.

The write off amount is debited as the expense in the period approved to write off in the income statement. It does not affect the sales performance of the entity in the current period and the previous period. The Matching Principle requires that revenues and their related expenses be recorded in the same accounting period. The revenue of $10,000 and the expense of $5,000 should be reported in June, the month when the revenue is reported as earned.

Because the risk to the business is relative to the number of accounts and the amount of cash tied up in receivables, larger companies cannot take a “wait and see” approach to capturing potential bad debts. Under the direct write-off method, bad debts expense is first reported on a company’s income statement when a customer’s account is actually written off. Often this occurs many months after the credit sale was made and is done with an entry that debits Bad Debts Expense and credits Accounts Receivable.

For example, if you’re deciding between opening a new location or investing in new equipment, DCF can help you compare the expected returns and results of both options to make the best decision. Whether you’re investing in new equipment or launching a new product, DCF can help you determine if that investment is worth the expense. It also allows you to easily see if the long-term returns will outweigh the initial cost. This article is not intended to provide tax, legal, or investment advice, and BooksTime does not provide any services in these areas. This material has been prepared for informational purposes only, and should not be relied upon for tax, legal, or investment purposes. BooksTime is not responsible for your compliance or noncompliance with any laws or regulations.

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. The direct write off method is a way businesses account for debt can’t be collected from clients, where the Bad Debts Expense account is debited and Accounts Receivable is credited. In other words, it can be said that whenever a receivable is considered to be unrecoverable, this method fully allows them to book those receivables as an expense without using an allowance account. It should also be clarified that this method violates the matching principle. As in, Expenses must be reported in the period in which the company has incurred the revenue.