The direct write-off method involves writing off a bad debt expense directly against the corresponding receivable account. Bad debt is an accounting term which refers to the debt when a debtor or the accounts receivables of the entity becomes uncollectible due to the inability of the customer to pay back the amount due from him when the sale is made on credit. It is also referred to as uncollectible receivables. Following the direct write-off method of accounting can help business owners manage bad debts easily and effectively.
Did You Know? An entity that has bad debt at the year-end can write off that bad debt in their annual tax return.
What is the Direct Write-Off Method?
The direct write-off method is a method of accounting by which the accounts receivables are. This is done by debiting the bad debts account and crediting accounts receivables. The direct write-off method is followed for reporting income tax in the US.
One important point is that the direct write-off method contravenes the matching principle. The matching principle requires the expenses to be reported in the period in which it is incurred. At the same time, the direct write-off method states that the bad debt is reported when the debtors or the accounts receivables are written off, which may take several months after the sale has been made.
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Accounting of The Direct write Off Method
Under the Direct write Off Method, a credit memo is created to write off the accounts receivables of the customer under consideration. The credit memo is then used to offset the amount of the bad debt. The credit memo is created by debiting the bad debt expense account and crediting the accounts receivable account. In the Direct write Off Method of accounting, the amount of the bad debt expense is increased and does not involve any reduction in the amount of the sale recorded in the books of accounts.
Advantages of the Direct Write-Off Method
A Few Advantages of the Direct write Off Method are:
1. Writing off Tax
Although the Direct write-off method of accounting doesn’t follow the Generally Accepted Accounting Principles (GAAP), the IRS requires companies to use this method of accounting for filing their tax returns. Companies that have bad debt accounts in their books of accounts can write them off while filing their annual tax returns. Hence, a major advantage of following the direct write-off method is that the companies can write off bad debts from their taxable income.
2. Simple Method of Accounting
The Direct write-off method of accounting is considered an easy way to consider bad debts in the books of accounts. The first transaction is to the bad debts accounts, and the other is to the accounts receivables account by the amount owned by the customer.
3. Method Is Based on The Actual Amount
Unlike the allowance method of accounting in which the amount to be written off is estimated by the management, the Direct write off method of accounting is based on the actual amount of sum not received by the entity or the actual sum of money which is to be written off as bad debt. Thus, there is less or no risk of overstating or understating the expense.
Disadvantages of the Direct Write-Off Method
Although the direct write-off method of accounting has a lot of advantages, it also has some disadvantages. Below are some disadvantages of following the direct method of accounting.
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Inaccurate Balance Sheet
One disadvantage of the direct write-off method of accounting is that since the method states that the accounts receivable account should be credited, it gives a false view of the company's accounts receivables. Hence, the balance sheet prepared is inaccurate.
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Accounts receivables account is overstated.
Under the direct write-off method of accounting, the full amount of the sum owned by the customer is reported by the entity when the credit sale is made. This is what is referred to as accounts receivable. Nevertheless, if the entity has a huge amount of accounts receivable which could not be collected, the amount in the accounts receivable account would be too high.
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Contravenes The Use of GAAP
The direct write-off method of accounting contradicts the use of GAAP. This is because of how the method records items on the Balance Sheet. The financial statements do not give a precise and accurate picture of the business done by the entity.
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Direct Write-Off Method Vs. Allowance Method
Although both direct write-off and allowance methods are well-known accounting methods, there is some difference between the two. The direct write-off method is much simpler than the allowance method.
As per the direct write-off method, the business owners are required to write off the actual sum of money not received by the entity and which can be written off as bad debt. Only one journal entry is passed to write off the uncollected sum of money. This makes it easier for small business owners to follow this method of accounting.
On the contrary, the allowance method requires the business owners to estimate the amount which will be written off as bad debt at the year's end. This estimated amount is then debited from the bad debts accounts and is credited to the allowance for doubtful accounts.
Direct Write Off should be Followed with Prudence
The business owners and the companies must be precise in writing off bad debts in the books of accounts as this affects both the Balance Sheet and the Income statement. Although the direct write-off method is the easiest and simplest method to eliminate bad debt from the books of accounts, it should be used with prudence and caution.
If the entity has uncollectible accounts consistently, the entity must follow the allowance method for writing off the bad debt. This is because the allowance method follows GAAP rules. The allowance method helps prepare more reliable and accurate financial statements, thereby giving a correct picture of the entity's state of affairs.
Also Read: How accounting system helps companies to manage financial records
Conclusion:
Any business can reasonably realize bad debts using the direct write-off approach. When a customer cannot pay back the amount owed when the sale is made on credit, the debtor or the entity's accounts receivable becomes uncollectible. This is referred to as bad debt. Additionally known as uncollectible receivables. The direct write-off method of accounting can assist business owners in efficiently and readily managing bad debts. After considering every one of these arguments, it is decided that an accounting transaction does not have to be straightforward to record. Therefore, it is not recommended to book for uncollectible receivables using the direct write-off method.
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