You can also turn to Skynova's full suite of online software modules to help with your small business needs, from invoicing to submitting professional retainers, credit notices, and work orders. Skynova gives you the means to resolve bad debt with good business practices. In deciding which method to use to account for bad debt, you need to understand the benefits and disadvantages of the direct write-off method. Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries.

Direct write off method definition

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 of the sale. For these reasons, the accounting profession does not allow the direct write-off method for financial reporting.

Estimating the Bad Debt Expense

• The balance sheet method is another simple method for calculating bad debt, but it too does not consider how long a debt has been outstanding and the role that plays in debt recovery.
• Accounts receivable is reported on the balance sheet; thus, it is called the balance sheet method.
• The calculation matches bad debt with related sales during the period.
• The allowance method provides in advance for uncollectible accounts think of as setting aside money in a reserve account.
• The direct write-off method is one of the two commonly known methods of treating bad debt expense.
• The adjusted balance in Allowance for Doubtful Accounts should be $31,800.

Since the current balance is $17,000, we need to increase the balance to $31,800. Every time a business extends payment terms to a customer, that business is taking on risk. In the direct method of accounting, bad debt expense is booked when all attempts of recovery have been exhausted and there is no chance of receiving the money.

Direct Write-Off and Allowance Methods

The aging method is a modified percentage of receivables method that looks at the age of the receivables. The longer a debt has been outstanding, the less likely it is that the balance will be collected. The aging method breaks down receivables https://www.bookstime.com/articles/preparing-a-bank-reconciliation based on the length of time each has been outstanding and applies a higher percentage to older debts. The contra-asset, Allowance for Doubtful Accounts, is proportional to the balance in the corresponding asset, Accounts Receivable.

Generally, it can also be referred to broadly as something that helps to lower an annual tax bill. We must create a holding account to hold the allowance so that when a customer is deemed uncollectible, we can use up part of that allowance to reduce accounts receivable. Allowance for Doubtful Accounts is a contra-asset linked to Accounts Receivable.

Accounting 101

The direct method treats a bad account as an expense when it's clear that you can't collect it and is required for federal income tax purposes. The allowance method is the other way to account for bad debt and is preferred by professional accountants as the more accurate way to handle uncollectible receivables. This journal entry eliminates the $500 balance in accounts receivable while creating an account for bad debt. The balance of the Allowance for Bad Debt account is subtracted from your revenue account to reduce the revenue earned. The direct write-off method waits until an amount is determined to be uncollectible before identifying it in the books as bad debt.

Direct write-off method Vs. Allowance method

The allowance is used the reduce the net amount of receivables that are due while leaving all the customer balances intact. The direct write-off method is an easier way of treating the bad debt expense since it only involves a single entry where bad debt expense is debited and accounts receivable is credited. Hence, the bad debt expense recorded each year is matched to the net sales for the year as per the matching principle of accounting. At the end of an accounting period, the Allowance for Doubtful Accounts reduces the Accounts Receivable to produce Net Accounts Receivable. Note that allowance for doubtful accounts reduces the overall accounts receivable account, not a specific accounts receivable assigned to a customer.

To record the bad debt, which is an adjusting entry, debit Bad Debt Expense and credit Allowance for Doubtful Accounts. When a customer is identified as uncollectible, we would credit Accounts Receivable. We cannot debit bad debt because we have already recorded bad debt to cover the percentage of sales that would go bad, including this sale.

• Every time a business extends payment terms to a customer, that business is taking on risk.
• On to the calculation, since the company uses the percentage of receivables we will take 6% of the $530,000 balance.
• The journal entry for the Bad Debt Expense increases (debit) the expense’s balance, and the Allowance for Doubtful Accounts increases (credit) the balance in the Allowance.
• As well, all accounting data from the software's subledgers are transferred to the general ledger.

A write-off is an extreme version of a write-down, where the book value of an asset is reduced below its fair market value. For example, damaged equipment may be written down to a lower value if it is still partially usable, and debt may be written down if the borrower is only able to repay a portion of the loan value. Tax credits are applied to taxes owed, lowering the overall tax bill directly. On the contrary, the allowance method allows you to book a provision for the doubtful debt at the end of each year. 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.

• We cannot debit bad debt because we have already recorded bad debt to cover the percentage of sales that would go bad, including this sale.
• Although only publicly held companies must abide by GAAP rules, it is still worth considering the implications of knowingly violating GAAP.
• This approach matches revenues with expenses, so that all aspects of a sale are included within a single reporting period.
• In the direct method of accounting, bad debt expense is booked when all attempts of recovery have been exhausted and there is no chance of receiving the money.
• We must make sure to show that Joe Smith paid the amount he owed, not just the fact that the company received some cash.