Direct Write-Off and Allowance Methods Financial Accounting

This estimate is based on the sales and collections information from previous years and is reported by setting up a holding account called the allowance for doubtful accounts x. This accounting principle allows for the client’s balance to remain while reducing the accounts receivable on the balance sheet by creating a contra-asset account. 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. It does so with a $2,000 credit to the accounts receivable account and an offsetting debit to the bad debt expense account.

Unit 10: Receivables

This is considered an expense because bad debt is a cost of doing business. Part of the cost of allowing customers to borrow money, which is essentially what a customer is doing when the business allows the customer time to pay, is the expense related to uncollectible receivables. Seeing and considering all these points, it is concluded that only being a simple method to record the transaction is not the requirement of an accounting transaction. It must be within the rules and laws framed by the bodies for an accounting of transactions so that a true and correct picture of the Financial Statements can be shown to the stakeholder of the entity.

Hence, the company won’t be showing the true and fair view of itsfinancial statements if the direct write-off method was used since it violatesthe basic principles of accounting. Contrary to the treatment in the allowance method, we report the bad debt expense when it occurs in the direct write-off method. These practical examples highlight the differences in how bad debts are accounted for under each method, emphasizing the importance of selecting the appropriate method based on the business’s needs and circumstances.

• By adjusting accounts receivable for estimated bad debts, the balance sheet reflects the net realizable value of receivables, providing stakeholders with a clearer understanding of what the company expects to collect.
• Under the direct write-off method, bad debt expense serves as a direct loss from uncollectibles, which ultimately goes against revenues, lowering your net income.
• For these reasons, the accounting profession does not allow the direct write-off method for financial reporting.
• Suppose a business identifies an amount of 200 due from a customer as irrecoverable as the customer is no longer trading.
• The direct write off method is simpler than the allowance method as it takes care of uncollectible accounts with a single journal entry.

How to Estimate Accounts Receivables

Under this method, bad debt is recognized and written off only when it is determined to be uncollectible. When a specific account is identified as bad debt, the company records a bad debt expense and reduces accounts receivable by the same amount. The allowance method is used to allow for bad debts on the income statements. Since the allowance method uses an estimated amount, it is not as accurate as of the direct write off method.

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. In this scenario, $600 would be credited to your company’s revenue, while $600 would be debited from accounts receivable. You realise after a few months of attempting to collect on the $600 invoice that you will not be paid for your services. Using the direct write-off technique, a debit of $600 will be recorded to the bad debt expense account, and a credit of $600 will be made to accounts receivable.

Compare the Timing of Bad Debt Recognition Between the Two Methods

The $14,800 is the amount of Bad Debt Expense that must be recorded. The direct write-off method allows a business to record Bad Debt Expense only when a specific account has been deemed uncollectible. The account is removed from the Accounts Receivable balance and Bad Debt Expense is increased.

Comparing the Two Methods

This is usually not in the same accounting period as the one in which the invoice was raised. The bad debts expense account is debited for the actual amount of the bad debt. This directly impacts both the revenue as well as the outstanding balance due to the company. It causes an inaccuracy in the revenue and outstanding dues for both the accounting period of the original invoice as well as the accounting period of it being classified as a bad debt. The Direct Write-Off Method is a simple approach to accounting for bad debt.

What does Coca-Cola’s Form 10-k communicate about its accounts receivable?

• For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.
• If a company takes a percentage of sales (revenue), the calculated amount is the amount of the related bad debt expense.
• Allowance for Doubtful Accounts is a contra-asset linked to Accounts Receivable.

As a result, the balance sheet is likely to report an amount that is greater than the amount that will actually be collected. It can also result in the Bad Debts Expense being reported on the income statement in the year after the year of the direct write off method journal entry sale. For these reasons, the accounting profession does not allow the direct write-off method for financial reporting. Instead, the allowance method is to be used for the financial statements. 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.

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.

When and How Bad Debts Are Recognized

When you use the allowance method, you may have correctly estimated the bad debt in the first quarter. This would accurately reduce the revenue shown in the first quarter and have no effect on the subsequent accounting periods. 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. Since bad debts are recognized only when they occur, there is an immediate effect on the financial results for that period. This provides a clear and transparent record of actual bad debt expenses incurred.

If you are looking for a holistic and automated tool to manage payroll, employees, expenses, contractor management, Deskera People could be the apt solution. According to the Houston Chronicle, the direct write-off procedure violates generally accepted accounting rules (GAAP). The problem with this method is that the income statement is affected by an activity that may not be related to its preparation period. These kinds of customers are normally put on the blacklist in the business world, and entities should not continue doing business with them.

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. When using the percentage of sales method, we multiply a revenue account by a percentage to calculate the amount that goes on the income statement. Bad debt expense also helps companies identify which customers default on payments more often than others. The direct write-off technique is the most straightforward way to book and record a loss on uncollectible receivables, although it violates accounting standards.

Total revenue is now incorrect in both the period in which the invoice was recorded and the period in which the bad debt was expensed. Bad debt is entered as an adjusting entry on the financial statements for the company and flows to the balance sheet. Accounts receivable can be negative if more credit is issued to clients than actual revenue collected. The most important thing to remember when working with the allowance methods for bad debt is to know what you have calculated!