Direct Write-Off Method vs the Allowance Method for Bad Debt

This entry removes the receivable from the books and records the expense in the income statement. Therefore, there is no guaranteed way to find a specific value of bad debt expense, which is why we estimate it within reasonable parameters. The accounts receivable department may write off uncollectible accounts because it is no longer worth spending effort on collecting the debt. In some cases, the cost of pursuing the debt might outpace the amount owed. For example, going to court might cost more upfront in legal fees and labor hours than the unpaid debt. HighRadius helps accounting and finance teams simplify and accelerate the financial close and reporting process.

Leveraging Technology for Credit Management

• Bad debts in business commonly come from credit sales to customers or products sold and services performed that have yet to be paid for.
• When using the percentage of accounts receivable method, the amount calculated is the new balance in allowance for doubtful accounts.
• It delays recognition of bad debts, which can make your income look better or worse than it really is in the short term.
• Default in debt provided to a client or a third party can be a major pain point for businesses.
• As you can see, writing off an account should only be done if you are completely certain that the full account is uncollectable.
• A written explanation outlining the rationale behind the decision to write off the debt further strengthens the legitimacy of the action.
• When it’s clear a customer is not going to pay—due to possible bankruptcy, flat-out ghosting, or any other reason—you directly write off the amount of their debt.

Once again, the percentage is an estimate based on the company’s previous ability to collect receivables. GAAP requires these larger companies to follow the Matching Principle–matching expenses (or potential expenses) to the same accounting period where the revenue is earned. The Direct Write-off Method only captures an expense when a company determines a debt to be uncollectible.

Step 1: Provide Service on Credit

• The bad debts expense account is debited for the actual amount of the bad debt.
• Unlike the Allowance Method, which estimates bad debts in advance, the Direct Write-Off Method records bad debts as they occur.
• This is the simplest way to recognize a bad debt, since the entry is only made when a specific customer invoice has been identified as a bad debt.
• This directly impacts both the revenue as well as the outstanding balance due to the company.
• This estimated amount is recorded as a bad debt expense and a corresponding credit to the allowance for doubtful accounts.
• For example, in one accounting period, a company can experience large increases in their receivables account.

If the company underestimates the amount of bad debt, the allowance can have a debit balance. If the company uses a percentage of sales method, it must ensure that there will be enough in Allowance for Doubtful Accounts to handle the amount of receivables that go bad during the year. The percentage of sales method is based on the premise that the amount of bad debt is based on some measure of sales, either total sales or credit sales. Based on prior years, a company can reasonably estimate what percentage of the sales measure will not be collected. If a company takes a percentage of sales (revenue), the calculated amount is the amount of the related bad debt expense.

Revenue Reconciliation

• As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy.
• Whereas management estimates the write-off in the allowance method, the direct write-off method is based on an actual amount.
• Because this is just another version of an allowance method, the accounts are Bad Debt Expense and Allowance for Doubtful Accounts.
• The percentage of receivables method is a balance sheet approach, in which the company estimate how much percentage of receivables will be bad debt and uncollectible.
• These tactics empower companies to safeguard assets and foster stronger customer relationships.

Credit checks help identify potential risks and prevent extending credit to high-risk customers. Communicating this policy clearly to customers ensures mutual understanding and reduces disputes. After several attempts to collect payment, the client is unresponsive and declares bankruptcy. The firm decides to write off the amount using the direct write-off method. Adapting bad debt policies to industry specifics improves accuracy and relevance. Using such tools can increase efficiency, reduce errors, and provide valuable insights into credit management the direct write-off method is used when performance.

• When doing the calculations, it is important to understand what the resulting number actually represents.
• 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.
• Each invoice should have a unique identifier for straightforward tracking, and offering multiple payment options can accommodate a wider range of customer preferences.
• Providing discounts or other incentives for early payments can motivate customers to pay faster, improving cash flow and reducing the risk of late or missed payments.

Calculate bad debt expense direct write off method

In the direct write off method, the bad debts expense account is debited and the accounts receivable is credited. This is the opposite of the usual practice of an unpaid invoice being a debit in the accounts receivable account. This is because the accounts receivable is an asset and increase when you debit it. The Direct Write-Off Method is a simple approach to accounting for bad debt.

Some businesses begin with the direct write-off method due to its simplicity and ease of use but later transition to the allowance method as their operations expand. The matching principle dictates that expenses should be recorded in the same period as the revenues they helped generate. In the case of bad debts, this means estimating potential losses when the revenue is earned, not months later when a debt assets = liabilities + equity becomes clearly uncollectible. 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. While the Direct Write-Off Method is simple and direct, its delayed recognition of bad debt and non-compliance with GAAP make it less desirable for accurate financial reporting.

Order to Cash

Because customers do not always keep their promises to pay, companies must provide for these uncollectible accounts in their records. The direct write-off method recognizes bad accounts as an expense at the point when judged to be uncollectible and is the required method for federal income tax purposes. The allowance method provides in advance for uncollectible accounts think of as setting aside money in a reserve account. The allowance method represents the accrual basis of accounting and is the accepted method to record uncollectible accounts for financial accounting purposes. However, the direct write-off method can result in misstating the income between reporting periods if the bad debt journal entry occurred in a different period from the sales entry. For such a reason, it is only permitted when writing off immaterial amounts.

Compare the Timing of Bad Debt Recognition Between the Two Methods

In such cases, Outsource Invoicing the company reverses the write-off entry and records the cash received. This is known as a bad debt recovery and is recognized as income in the period of collection. Bad debt expense also helps companies identify which customers default on payments more often than others.

Unlike the allowance method, there is no estimation involved here as the company specifically choose which accounts receivable to write off and record bad debt expense immediately. Likewise, the company may record bad debt expense at any time during the period. It is useful to note that when the company uses the percentage of sales to calculate bad debt expense, the adjusting entry will disregard the existing balance of allowance for doubtful accounts.