The Direct Write off Method vs the Allowance Method

Therefore, companies should only use this method for small amounts that do not significantly impact financial records. The sales method applies a flat percentage to the total dollar amount of sales for the period. For example, based on previous experience, a company may expect that 3% of net sales are not collectible. If the total net sales for the period is $100,000, the company establishes an allowance for doubtful accounts for $3,000 while simultaneously reporting $3,000 in bad debt expense. The entry to write off a bad account depends on whether the company is using the direct write-off method or the allowance method. In this scenario, $600 would be credited to your company’s revenue, while $600 would be debited from accounts receivable.

• Allowance for uncollectible accounts is also referred to as allowance for doubtful accounts, and may be expensed as bad debt expense or uncollectible accounts expense.
• Under the direct write-off method of accounting, the full amount of the sum owned by the customer is reported by the entity when the credit sale is made.
• The use of the allowance method is intended to match a bad debt expense with credit sales of the same period, from which a loss of accounts receivable occurs in the future.

What is the direct write-off method?

This shall give us a deeper understanding of the process and its intricacies. Although the direct write-off method of accounting has a lot of advantages, it also has some disadvantages. He owed you an amount of $400 against purchases he made in 2017 thathe can’t pay anymore since his bank loans exceeded his net assets.

• A business that uses the direct write-off method records the full amount of an account receivable at the time of a sale.
• It also deals in actual losses instead of initial estimates, which can be less confusing.
• Instead of creating a provision on 2018, Nina will write off thebad debt in 2019 by debiting the bad debt expense account and crediting theaccounts receivable as shown below.
• This is the opposite of the usual practice of an unpaid invoice being a debit in the accounts receivable account.

Overview of the Direct Write-Off Method

The balance sheet will reflect greater revenue than was earned, which is against GAAP rules. This is why GAAP prohibits financial reporting using the direct write-off approach. When preparing financial statements, the allowance technique must be employed.

Direct Write-Off Method Vs Allowance Method

For IRS tax returns, the direct write-off approach is required, as the allowance method is insufficiently precise. The allowance approach, similar to putting money in a reserve account, anticipates uncollectible accounts. The allowance method is the standard technique for recording uncollectible accounts for financial accounting objectives and represents the accrual foundation of accounting. As mentioned above, there are no requirements for creating a provision or reporting a bad debt expense every year in this method. The direct write-off method is more appropriate for writing-off bad debts for the preparation of tax returns or if the cash basis of accounting is used.

What is the Direct Write-off Method and why is it Important?

In the allowance method, an estimate is calculated every year that is debited to the bad debt expense account. The direct write off method is best for small businesses or those using cash basis accounting. It’s ideal if you don’t have many uncollectible accounts or if your invoices are typically paid quickly. 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. You can deduct bad debts from your total taxable income when filing a company tax return.

The business owners and the companies must be precise in writing off bad debts in the books of accounts as this affects both the Balance Sheet and the Income statement. Although the direct write-off method is the easiest and simplest method to eliminate bad debt from the books of accounts, it should be used with prudence and caution. It would still be better if the bad debt expenses are booked asper the allowance method but wouldn’t really affect the reliability offinancial statements since the amount is immaterial.

Another advantage is that companies can write off their bad debt on their annual tax returns. A disadvantage of the direct write-off method is the possibility of expense manipulation, because companies record expenses and revenue in different periods. The allowance method records bad debt expense by estimating uncollectible accounts at the end of the accounting period. -Footnote Generally accepted accounting principles (GAAP), however, require companies with a large amount of receivables to use the allowance method.

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. The Direct Write-Off Method offers a simple approach to managing bad debts, particularly for small businesses. While it has its limitations, understanding its application and implications is Direct Write Off Method Definition essential for accounting professionals and those preparing for Canadian accounting exams. By mastering this method, you will be better equipped to handle receivables and ensure accurate financial reporting. Before exploring the Direct Write-Off Method, it’s essential to grasp the concept of bad debts.

As a result, most well-known companies such as General Electric, Pepsi, Intel, and FedEx use the allowance method. Using the direct write off method, Beth would simply debit the bad debt expense account for $100 and credit the accounts receivable account for the same amount. This effectively removes the receivable and records the loss Beth incurred from the non-creditworthy customer. One of her customers purchased products worth $ 1,500 a year ago, and Natalie still hasn’t been able to collect the payment. After trying to contact the customer a number of times, Natalie finally decides that she will never be able to recover this $ 1,500 and decides to write off the balance from such a customer. 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.

For these reasons, the accounting profession does not allow the direct write-off method for financial reporting. One important point is that the direct write-off method contravenes the matching principle. The matching principle requires the expenses to be reported in the period in which it is incurred. The allowance method follows GAAP matching principle since we estimate uncollectible accounts at the end of the year. 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). The direct write-off method is used only when we decide a customer will not pay.

Problem Between The Direct Write-Off Method and GAAP

The allowance method provides in advance for uncollectible accounts think of as setting aside money in a reserve account. The allowance method represents the accrual basis of accounting and is the accepted method to record uncollectible accounts for financial accounting purposes. Under the Direct write Off Method, a credit memo is created to write off the accounts receivables of the customer under consideration. The credit memo is created by debiting the bad debt expense account and crediting the accounts receivable account.

Accounts receivables account is overstated.

Because customers do not always keep their promises to pay, companies must provide for these uncollectible accounts in their records. 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. Companies only have to make two transactions for the amount of the customer’s bad debt.

The direct write off method is simpler than the allowance method as it takes care of uncollectible accounts with a single journal entry. It’s certainly easier for small business owners with no accounting background. It also deals in actual losses instead of initial estimates, which can be less confusing. It is waived off using the direct write-off method journal entry to close the specific account.