What is the Direct Write Off Method?
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.
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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.
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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.