What are the differences between direct write-off method and allowance method of recording bad debt expense which method is more suitable with matching principle?

What happens when a customer doesn’t pay for products or services? The business is left out of pocket with “bad debt” to balance in the books. The direct write off method offers a way to deal with this for accounting purposes, but it comes with some pros and cons.

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.

Direct write off method GAAP compliance

One issue that immediately crops up when it comes to this method is that of direct write off method GAAP compliance. The direct write off method doesn’t comply with the GAAP, or generally accepted accounting principles.

GAAP states that expenses and revenue must be matched within the same accounting period. However, the direct write off method allows losses to be recorded in different periods from the original invoice dates. This means that reported losses could appear on the income statement against unrelated revenue, which distorts the balance sheet. It will report more revenue than might have actually been generated.

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.

Direct write off method vs. the allowance method

The allowance method offers an alternative to the direct write off method of accounting for bad debts. With the allowance method, the business can estimate its bad debt at the end of the financial year. Rather than writing off bad debt as unpaid invoices come in, the amount is tallied up only at the end of the accounting year.

The estimated amount is debited from the Bad Debts Expense and credited to an Allowance for Doubtful Accounts to maintain balance.

Direct write off method advantages

There are several advantages to using the direct write off method:

1. Straightforward procedure: The direct write off method offers a simple way to deal with unpaid debts. You only need to list two transactions for each unpaid invoice, with greater flexibility on timings.

2. Tax deductions: You can write off your bad debt on annual tax returns, according to the IRS. By contrast, the IRS won’t accept bad debts written off using the allowance method, because it uses estimates rather than precise figures.

3. Precision: Because it’s based on factual amounts gleaned directly from invoices, the direct write off method prevents errors in your financial reporting.

Direct write off method disadvantages

At the same time, there are some disadvantages to be aware of:

1. It goes against the matching principle: According to the matching principle in accounting, expenses must be reported in the same period that they were incurred. Bad expenses might not be recognized until later on with the direct write-off method, which would lead to a mismatch.

2. It can cause inaccuracy: The mismatch in timings mentioned above could also cause an inaccuracy in your business’s balance sheet. Crediting the accounts receivable could overstate profit.

3. It causes GAAP violations: The GAAP doesn’t allow use of the direct write off method because of these inaccuracies. Financial statements might not accurately reflect a business’s true financial standing.

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December 26, 2019

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. For example, a graphic designer makes a new logo for a client and sends the files with an invoice for $500, but the client never pays and the designer decides the client won’t ever pay, so she debits Bad Debts Expense for $500 and credits Accounts Receivable for $500.

In this article, we’ll cover:

• What Is the Direct Write off Method?

NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.

What Is the Direct Write off Method?

• The direct write off method is one of two methods to account for bad debts in bookkeeping. The other method is the allowance method. A bad debt is an amount owing that a customer will not pay.In the direct write off method, a small business owner can debit the Bad Debts Expense account and credit Accounts Receivable.
  • For example, a graphic designer makes a new logo for a client and sends the files with an invoice for $500. The client doesn’t respond to follow up calls and emails about the unpaid invoice. The designer decides the client won’t ever pay. She debits Bad Debts Expense for $500 and credits Accounts Receivable for $500.

  Unpaid invoices usually appear as debits in accounts receivable. Also important: unpaid invoices are considered assets (something of monetary value to a company). When an asset increases, it is a debit in accounting. When an asset decreases, it is a credit, according to Accounting Coach

  Bad debts can be written off from total taxable income on a business’s tax return. The IRS requires small businesses to use the direct write off method to calculate these deductions. The allowance method asks businesses to estimate their amount of bad debt, which isn’t an accurate enough way to calculate a deduction for the IRS.

  People also ask:

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 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

The allowance method requires a small business to estimate at the end of the year how much bad debt they have, while the direct write off method lets owners write off bad debt whenever they decide a customer won’t pay an invoice.

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.

THE ALLOWANCE METHOD

Under the allowance method, a company needs to review their accounts receivable (unpaid invoices) and estimate what amount they won’t be able to collect. This happens at the end of the year. This estimated amount is then debited from the account Bad Debts Expense and credited to a contra account called Allowance for Doubtful Accounts, according to the Houston Chronicle.

THE DIRECT WRITE OFF METHOD

Under the direct write off method, when a small business determines an invoice is uncollectible they can debit the Bad Debts Expense account and credit Accounts Receivable immediately. This eliminates the revenue recorded as well as the outstanding balance owed to the business in the books.

What Is Wrong with the Direct Write off Method?

The direct write off method violates GAAP, the generally accepted accounting principles. GAAP says that all recorded revenue costs must be expensed in the same accounting period. This is called the matching principle, according to Accounting Tools.

But, the write off method allows revenue to be expensed whenever a business decides an invoice won’t be paid. This makes a company appear more profitable, at least in the short term, than it really is.

• For example, revenue may be recorded in one quarter and then expensed in another, which artificially inflates revenue in the first quarter and understates it in the second.

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