Under the direct write-off method, uncollectible accounts expense is recognized

Under the direct write-off method, a bad debt is charged to expense as soon as it is apparent that an invoice will not be paid. Under the allowance method, an estimate of the future amount of bad debt is charged to a reserve account as soon as a sale is made. This results in the following differences between the two methods:

Timing Differences

Bad debt expense recognition is delayed under the direct write-off method, while the recognition is immediate under the allowance method. This results in higher initial profits under the direct write-off method.

Accuracy Differences

The exact amount of the bad debt expense is known under the direct write-off method, since a specific invoice is being written off, while only an estimate is being charged off under the allowance method.

Receivable Line Item Differences

The receivable line item in the balance sheet tends to be lower under the allowance method, since a reserve is being netted against the receivable amount.

The direct write off method involves charging bad debts to expense only when individual invoices have been identified as uncollectible. This method can be considered a reasonable accounting method if the amount that is written off is an immaterial amount, since doing so has minimal impact on an entity's reported financial results, and so would not skew the decisions of a person using the company's financial statements. This method is required for the reporting of taxable income in the United States, since the Internal Revenue Service believes (possibly correctly) that companies would otherwise be tempted to inflate their bad debt reserves in order to report a smaller amount of taxable income.

Accounting for the Direct Write-Off Method

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. Creating the credit memo creates a debit to a bad debt expense account and a credit to the accounts receivable 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. Thus, the revenue amount remains the same, the remaining receivable is eliminated, and an expense is created in the amount of the bad debt.

Disadvantages of the Direct Write-Off Method

The direct write off approach violates the matching principle, under which all costs related to revenue are charged to expense in the same period in which you recognize the revenue, so that the financial results of an entity reveal the entire extent of a revenue-generating transaction in a single accounting period.

The direct write off method delays the recognition of expenses related to a revenue-generating transaction, and so is considered an excessively aggressive accounting method, since it delays some expense recognition, making a reporting entity appear more profitable in the short term than it really is. For example, a company may recognize $1 million in sales in one period, and then wait three or four months to collect all of the related accounts receivable, before finally charging some bad debts off to expense. This creates a lengthy delay between revenue recognition and the recognition of expenses that are directly related to that revenue. Thus, the profit in the initial month is overstated, while profit is understated in the month when the bad debts are finally charged to expense.

Direct Write-Off vs. Allowance Method

The alternative to the direct write off method is to create a provision for bad debts in the same period that you recognize revenue, which is based upon an estimate of what bad debts will be. This approach matches revenues with expenses, and so is considered the more acceptable accounting method.

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. 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.

You are free to use this image on your website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Direct write-off method (wallstreetmojo.com)

Bad Debts Expenses for the amount determined will not be paid directly charged to the profit and loss account under this method. The direct write-off method is used only when it is inevitable that a customer will not pay. There is no recording of the estimates or use of allowance for the doubtful accounts under the write-offWrite-offWrite off is the reduction in the value of the assets that were present in the books of accounts of the company on a particular period of time and are recorded as the accounting expense against the payment not received or the losses on the assets.read more methods.

The following entry should be passed:-

The write off amount is debited as the expense in the period approved to write off in the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more. It does not affect the sales performance of the entity in the current period and the previous period. It affects only the bottom lineBottom LineThe bottom line refers to the net earnings or profit a company generates from its business operations in a particular accounting period that appears at the end of the income statement. A company adopts strategies to reduce costs or raise income to improve its bottom line. read more of income in the current period. It is because the expenses are recognized in this period. It is probably against the matching principlesMatching PrinciplesThe Matching Principle of Accounting provides accounting guidance, stating that all expenses should be recognized in the income statement of the period in which the revenue related to that expense is earned. This means that, regardless of when the actual transaction is made, the expenses that are entered into the debit side of the accounts should have a corresponding credit entry in the same period.read more.

Table of contents

• What is the Direct write-off method?
  • Examples of Direct Write-Off Method
    • Example #1
    • Example #2
  • Advantages
  • Disadvantages
  • Reasons Why Direct Write-off Method is not preferred in the Accounting Profession?
  • Conclusion
  • Recommended Articles

Examples of Direct Write-Off Method

Example #1

Assume Natalie owns a shop of confectionery. Natalie has many customers who purchase goods from her on credit and pay. 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.

Example #2

An accounting firm prepares a company’s financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more as per the laws in force and hands over the Financial Statements to its directors in return for a Remuneration of $ 5,000. The remuneration has been outstanding for a year now. 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.

Advantages

• The main advantage of the Direct Write-off method is that it is straightforward to book and record in books of accounts. Companies only have to pass two journal entries for the amount of the customer’s bad debt.
•  The other advantage is that the company can write off its bad debts on its annual tax returns.
• The contra asset accountContra Asset AccountA contra asset account is an asset account with a credit balance related to one of the assets with a debit balance. When we add the balances of these two assets, we will get the net book value or carrying value of the assets having a debit balance.read more compilations are also avoided if this method is used.
• There are remote chances of error, considering no calculation of estimates of doubtful debts is required. The risk of overstating and understating expenses in the income statements is also minimized.
• Since tax returns are prepared on a cash basisCash BasisCash Basis Accounting is an accounting method in which all the company's revenues are accounted for only when there is an actual cash receipt, and all the expenses are recognized when they are paid. Small companies and individuals generally follow this accounting method.read more, this method of bad debt expenses is the most appropriate and would save us any extra calculations or work to prepare income tax returns.

Disadvantages

• The major disadvantage of the Direct Write-off method is the possibility of expense manipulation because companies record expenses and revenue in different periods.
• Another disadvantage of direct write-off is that the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more is not accurately representing the company’s accounts receivables.
• One major disadvantage is that it fails to maintain the financial statements according to the generally accepted accounting principle (GAAPGAAPGAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting.read more).
• A violation of accounting principles means that the financial statements are not portraying an accurate and fair view of the business.
• It goes against the accrual system of accounting and violates the matching principle and the prudence conceptPrudence ConceptPrudence Concept or Conservatism principle is a key accounting principle that makes sure that assets and income are not overstated and provision is made for all known expenses and losses whether the amount is known for certain or just an estimation i.e. expenses and liabilities are not understated in the books of accounting.read more.

Reasons Why Direct Write-off Method is not preferred in the Accounting Profession?

• The accounts receivable at the end of the financial year would be most likely to be reported in the balance sheet at an amount greater than the amount received from those receivables.
• The matching principle isn’t followed as the losses from this account are recognized as bad debts or several uncollectible periods after the income was earned
• The bad debts expenses resulting from the operating activities on credits will appear on the income statement or profit & loss account only after identifying these bad debts and altering them from the company’s accounts receivables.
• The contra asset account compilations are avoided if the direct write-off method is used. No provisions or reporting of provisions are required in this method.

Conclusion

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. It also ensures that the loss booked is based on actual figures and not on appropriation. But it violates the accounting principlesAccounting PrinciplesAccounting principles are the set guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while recording and presenting the financial information in the books of accounts.read more, GAAP, matching concepts, and a true and fair view of the Financial Statements.

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 transactionAccounting TransactionAccounting Transactions are business activities which have a direct monetary effect on the finances of a Company. For example, Apple representing nearly $200 billion in cash & cash equivalents in its balance sheet is an accounting transaction. read more.  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. Therefore it is not advised to use the Direct Write-off Method to book for the uncollectible receivables. Instead, the company should look for other methods such as appropriation and allowance for booking bad debts for its receivables.

Recommended Articles

This has been a guide to what is the Direct Write-off Method. Here we discuss how it works, examples, advantages, disadvantages, etc. You can learn more about accounting from the following articles –

What is the direct write

When an uncollectible account is written off the account to be credited is accounts?

When an account is to be written off as uncollectible when the direct write

When the direct write