The direct write-off method is an efficient way for your company to recognize a bad debt. Customers who owe money for a product or service but will not pay it back are said to have bad debt. In other words, it is money that they need to pay for a transaction or service that they will not pay and the corporation will not receive. Uncollectible receivables are another term for this. If you infrequently receive uncollected payments, then the direct write-off method can help your organization easily handle bad debt. In this post, you’ll learn how to use the direct write-off method in the journal entry for your business, as well as the potential benefits and drawbacks of the direct write-off.
What is the Direct Write-Off Method?
When individual invoices are designated as uncollectible, bad debts are charged to expenditure using 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. In the United States, this method is needed for reporting taxable revenue because the Internal Revenue Service feels (maybe rightly) that corporations would otherwise be inclined to inflate their bad debt reserves in order to report a lower amount of taxable income.
However, if the bad debt journal entry happened in a separate period than the sales entry, the direct write-off method may result in a misstatement of income between reporting periods. As a result, it is only permissible when writing off insignificant amounts. The direct write-off method’s journal entry is a debit to bad debt expense and a credit to accounts receivable.
Taking the Direct Write-Off Method Into Consideration
Under this method, the exact action performed to write off an account receivable with accounting software is to generate a credit memo for the customer in question. This offsets the amount of the bad debt. When you generate a credit memo, you debit a bad debt expense account and credit an accounts receivable account.
The method does not include a decrease in recorded sales, merely an increase in bad debt expenditure. For example, a company records a $10,000 transaction on credit as a debit to the accounts receivable account and a credit to the sales account. The consumer is only able to pay $8,000 of the open debt after two months, thus the vendor must write off $2,000. It does so by crediting the accounts receivable account by $2,000 and debiting the bad debt expenditure account by the same amount. As a result, the revenue amount remains unchanged. The remaining receivable is erased, and a cost in the amount of the bad debt is produced.
The Benefits of the Direct Write-Off Method
When running a business, it’s critical to grasp not only the direct write-off method but also its benefits. The following are some of the benefits of employing this method:
#1. Convenience
The method is seen as an easy way to deal with bad debts since it requires only two transactions; one to the bad debts expenditures account and the other to accounts receivable for the amount owed by the customer. The allowance method, on the other hand, compels you to declare bad debt expenses every fiscal year.
#2. Tax deduction
Companies that have bad debt can write it on their annual tax filings. This is because, despite the fact that the method does not adhere to Generally Accepted Accounting Principles (GAAP), the IRS forces businesses to utilize it on their tax filings. In other words, bad debt charges can be deducted from taxable income on a company’s tax return. The allowance method’s inaccuracy cannot be used in these cases. This is because the IRS requires an exact technique to calculate a deduction.
#3. It is predicated on a monetary value.
In the allowance method, management estimates the write-off, whereas the direct write-off method is based on an actual amount. The direct write-off method eliminates any errors in this respect, as well as the risk of overstating or misinterpreting any expenses.
Disadvantages of the Direct Write-off Method
While the direct write-off method can be beneficial to businesses, it also has a number of disadvantages. The following are some drawbacks of employing the direct write-off method:
#1. Infringes on the matching principle
As previously stated, using the direct write-off method violates the matching principle. This is due to the matching principle, which requires expenses to be recorded in the same period in which they were incurred. However, with this method, poor expenses may not be recognized as such until the next period. For example, if you made a sale at the conclusion of one accounting month that ended in December, you may not recognize the bad debts until the beginning of March. A direct write-off frequently occurs in a different year than when the sale was made, or when the revenue was recorded by your company.
#2. Inaccuracy in the balance sheet
Another downside of the direct write-off method is that it has an impact on the balance sheet. Because the direct write-off method involves crediting accounts receivable, it provides an inaccurate picture of a company’s accounts receivable.
#3. Infringes on GAAP
Because of how it records things on the balance sheet, using the direct write-off method also violates GAAP. Financial statements do not accurately depict how the business is doing financially.
#4. Accounts receivable are overstated
When a credit sale is performed, your company reports the full amount of what consumers owe using the direct write-off method. This is known as accounts receivable. However, if your organization has uncollectible accounts receivable, the quantity of accounts receivable would be excessive.
Examples
Here are some examples of how to use the direct write-off method:
Assume a craftsman made a rocking chair for your family and sent you a $300 bill. When the woodworker does not hear back from your family about paying the invoice, they assume you do not intend to pay. In this case, the craftsman would charge $300 to the bad debt expenditure account and $300 to the accounts receivable account.
You own a car repair shop and charge $3,000 to put a new engine in a customer’s vehicle. You have been attempting to reach the customer for the $3,000 invoice for months and have received no response. After this period, you consider it uncollectible and file it as a bad debt. In this situation, the accounts receivable account is lowered by $3,000 and a bad debt expense is reported.
Assume you produced a $600 wedding cake for a couple. After finishing the cake, you send them a $600 invoice. In this example, $600 would be credited to your company’s revenue and $600 would be deducted from accounts receivable. After a few months of attempting to collect on the $600 invoice, you realize you won’t be paid for your services. Using the direct write-off method, a $600 debit to the bad debt expense account and a $600 credit to accounts receivable will be made. This would be the inverse of the first transaction.
GAAP and The Direct Write Off Method
According to the Houston Chronicle, the direct write-off method violates generally accepted accounting rules (GAAP).
GAAP requires that expenses and revenue be matched throughout the same accounting period. The loss, however, may be recorded in a different accounting period than when the initial invoice was submitted under the direct write-off method.
This means that while the loss is recorded as an expense, it is offset on the income statement by revenue that is unrelated to the project. Total revenue is no longer correct in either the period in which the invoice was recorded or the period in which the bad debt was expensed.
This deviation violates GAAP rules since the balance sheet will show greater revenue than was earned. This is why, in financial reporting, GAAP does not permit the direct write-off method. When preparing financial statements, the allowance method must be employed.
The Allowance Method vs. the Direct Write Off Method
The allowance method requires a small business to estimate how much bad debt it has at the end of the year, but the direct write-off method allows owners to write off bad debt anytime they determine a client will not pay an invoice.
The direct write-off method is easier than the allowance method since it handles uncollectible accounts with a single journal entry. It’s obviously simpler for small business owners who don’t have accounting experience. It also deals with real losses rather than preliminary predictions, which might be less confusing.
Allowance Method
The allowance method requires a company to analyze its accounts receivable (unpaid invoices) and predict how much it will be unable to collect. This takes place at the conclusion of the year. According to the Houston Chronicle, this projected sum is subsequently deducted from the account Bad Debts Expense. It is then credited to a counter account named Allowance for Doubtful Accounts.
Direct Write Off Method
When a small business believes an invoice is uncollectible, they can instantly debit the Bad Debts Expense account and credit Accounts Receivable using the direct write-off method. This removes the revenue as well as the outstanding debt owed to the company from the books.
Is the Direct Method Still Utilized in Cash Flow Statements?
The direct method is one of two ways available for preparing the cash flow statement (or cash flow statement). The Financial Accounting Standards Board recommends the direct method (FASB). In reality, though, the indirect method is by far the most popular.
The Direct Method vs. the Indirect Method
Please see the following link for an overview of the differences between the two methodologies for preparing the statement of cash flows: The direct method vs. the indirect method.
With extreme caution, use the direct write-off method.
Write-offs have an impact on both the balance sheet and the income statement accounts on your financial statement. So it’s critical to be precise when dealing with bad debt write-offs. While the direct write-off method is the most convenient option to get rid of bad debt, it should be utilized sparingly and with prudence.
If you routinely have uncollectible accounts, adopt the allowance method for writing off bad debt because it adheres to GAAP while maintaining the accuracy of your financial statements. Using the allowance method might also assist you in creating more accurate financial estimates for your company.
Direct Write-off Method FAQs
Why is the direct write-off method unacceptable?
The direct write-off is prohibited under GAAP because it violates the matching principle, which requires that every transaction impacting one account, such as inventory, be matched with another account, such as cash.
What does it mean to write-off in accounting?
A write-off is the removal of uncollectible accounts receivable from the general ledger. A sum in accounts receivable signifies money owed to Cornell University. If the individual is unable to meet the obligation, the remaining balance must be written off after collection efforts have been made.
What is credit write-off?
A charged-off or written-off debt is one that has been substantially delinquent and has been abandoned by the lender.
