This distortion goes against GAAP principles as the balance sheet will report more revenue than was generated. 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.
Therefore the entire balance in Accounts Receivable will be reported as a current asset on the company’s balance sheet. 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 related party transaction of the sale. For these reasons, the accounting profession does not allow the direct write-off method for financial reporting. The direct write off method is simpler than the allowance method as it takes care of uncollectible accounts with a single journal entry. It also deals in actual losses instead of initial estimates, which can be less confusing.
After determining a debt to be uncollectible, businesses can use the direct write-off method to ensure records are accurate. Businesses can only take a bad debt tax deduction in certain situations, usually using what’s called the “charge-off method.” Read more in IRS Publication 535, Business Expenses. Bad debt, or the inability to collect money owed to you, is an unfortunate reality that small business owners must occasionally deal with. You’ll need to decide how you want to record this uncollectible money in your bookkeeping practices. Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent.
AccountingTools
Although only publicly held companies must abide by GAAP rules, it is still worth considering the implications of knowingly violating GAAP. Because write-offs frequently occur in a different year than the original transaction, it violates the matching principle; one of 10 GAAP rules. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.
While the direct write-off method doesn’t label a transaction as bad debt until it’s deemed uncollectible, the allowance method estimates ahead of time how much bad debt the business anticipates and records it in the sale period. 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. Big businesses and companies that regularly deal with lots of receivables tend to use the allowance method for recording bad debt. The allowance method adheres to the GAAP and reports estimates of bad debt expenses within the same period as sales. With the direct write-off method, there is no contra asset account such as Allowance for Doubtful Accounts.
For instance, a business may be aware of uncollectible debts, but may delay in writing them off, resulting in artificially inflated revenues. The direct write-off method can also wreak havoc on your profit and loss statement and perceived profitability, both before and after the bad debt has been written off. For example, Wayne spends months trying to collect payment on a $500 invoice from one of his customers. The direct write-off method does not comply with the generally accepted accounting principles (GAAP), according to the Houston Chronicle. The direct write-off method can be a useful option for small businesses infrequently dealing with bad debt or if the uncollectibles are for a small amount.
One method, the direct write-off method, should only be used occasionally, while the allowance method requires you estimate bad debt you expect before it even occurs. The direct write-off method allows you to write off the exact bad debt, not an estimate, meaning that you don’t have to worry about underestimating or overestimating https://www.kelleysbookkeeping.com/cash-basis-or-accrual-basis-accounting-what-s-better/ uncollectible accounts. While it’s not recommended for regular use, if your business seldom has bad debt, it can be a quick, convenient way to remove bad debt from your books. Bad debts in business commonly come from credit sales to customers or products sold and services performed that have yet to be paid for.
The matching principle states that any transaction that affects one account needs to affect another account during that same period. This credit card is not just good – it’s so exceptional that our experts use it personally. It features a lengthy 0% intro APR period, a cash back rate of up to 5%, and all somehow for no annual fee!
Direct Write-Off Method vs. Allowance Method
To keep the business’s books accurate, the direct write-off method debits a bad debt account for the uncollectible amount and credits that same amount to accounts receivable. If you don’t sell to your customers on credit, you won’t have any bad debt, but it’s likely that you’ll also have a much smaller customer base. 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.
- The direct write-off method can also wreak havoc on your profit and loss statement and perceived profitability, both before and after the bad debt has been written off.
- GAAP says that all recorded revenue costs must be expensed in the same accounting period.
- While it’s not recommended for regular use, if your business seldom has bad debt, it can be a quick, convenient way to remove bad debt from your books.
While this is not an issue for a business that uses the direct write-off method occasionally, if you regularly employ this method, your accounts receivable balance may be overstated, due to the uncollectible balances still on the books. A company that ends the year with bad debt can write that bad debt off on their tax return. In fact, The IRS requires businesses with bad debt to use the direct write-off method for their return, even though it does not comply with Generally Accepted Accounting Principles (GAAP). The direct write-off method lets you charge bad debts directly to an expense such as the Allowance for Bad Debt account used in the journal entries above.
If you’re wondering which method is best for your small business, speak with a professional for insights into your specific situation. Beginning bookkeepers in particular will appreciate the ease of the direct write-off method, since it only requires a single journal entry. If an old debt is paid, the journal entry can simply be reversed and the payment posted to the customer’s account. New business owners may find the percentage of sales method more difficult to use as historic data is needed in order to estimate bad debt totals for the upcoming year. This journal entry eliminates the $500 balance in accounts receivable while creating an account for bad debt.
What Is Wrong with the Direct Write off Method?
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.
Advantages of using the direct write-off method
The balance of the Allowance for Bad Debt account is subtracted from your revenue account to reduce the revenue earned. If you offer credit terms to your customers, you’ll have at least a few bad debt accounts. While stringent customer screening can help to reduce bad debt, it won’t eliminate it. 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.
