When deciding whether to use the direct write-off method or the allowance method to account for bad debts, you should consider a few things. The direct write-off method is easy to understand and doesn’t require a lot of paperwork, so it’s a good choice for these businesses. As a direct write-off method example, imagine that a business submits an invoice for $500 to a client, but months have gone by and the client still hasn’t paid.

As a one-time occurrence, you can deal with managing the inaccuracy of your financial statements, and it is faster and easier to do. The allowance method expects you to keep an ongoing contra asset account which might not be worth your time. During the COVID-19 crisis, many companies have been unable to execute their normal operating activities — and it’s still unclear how long the economic effects of the pandemic will last. If your company extends credit to customers, it’s prudent to reevaluate the adequacy of your bad debt allowance and make a reasonable adjustment to your reserves based on the disruption caused by COVID-19.

The Direct Write-Off Method Is Always the Best Option For Accounting For Bad Debts

Many businesses use a more refined version of the percentage-of-receivables approach, known as the Aging of receivables approach. This approach estimates bad debt expenses based on the balance in accounts receivable, but it also considers the uncollectible time period for each account. The balance sheet method (also known as the percentage of accounts receivable method) estimates bad debt expenses based on the balance in accounts receivable. The method looks at the balance of accounts receivable at the end of the period and assumes that a certain amount will not be collected.

(2) Adjust the Allowance for Bad Debts account to the balance calculated in step (1). Textbook content produced by OpenStax is licensed under a Creative Commons capital asset pricing model capm Attribution-NonCommercial-ShareAlike License . The allowance method is the more generally accepted method due to the direct write-off method’s limitations.

GAAP says that all recorded revenue costs must be expensed in the same accounting period. 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 allowance method lets companies estimate bad debts based on what has happened in the past and change the estimate as needed. This takes into account how uncertain it is to collect on accounts receivable.

• This has a direct influence on sales as well as the company’s outstanding balance.
• The bad debts expense account is debited and the accounts receivable is credited under the direct write-off technique.
• You’ll need to decide how you want to record this uncollectible money in your bookkeeping practices.
• Because of this, many businesses prefer the allowance method, which gives a more accurate picture of the company’s finances.

The contra account may also be called the Provision for Bad Debts or the Allowance for Bad Debts in practice. The final point relates to businesses with very little exposure to the possibility of bad debts, typically, entities that rarely offer credit to its customers. Assuming that credit is not a significant component of its sales, these sellers can also use the direct write-off method. The companies that qualify for this exemption, however, are typically small and not major participants in the credit market.

The Direct Write-Off Method: Should You Use It In Your Business?

Accounts receivable is reported on the balance sheet; thus, it is called the balance sheet method. 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. Some customers may have requested extended payment terms during the COVID-19 crisis, which could cause an increase in older receivables on your company’s aging schedule.

The Weaknesses of the Direct Write-Off Method – Introduction to the Direct Write-Off Method for Beginners

This would accurately reduce the revenue shown in the first quarter and have no effect on the subsequent accounting periods. The allowance method is the more widely used method because it satisfies the matching principle. The allowance method estimates bad debt during a period, based on certain computational approaches. When the estimation is recorded at the end of a period, the following entry occurs. For instance, some companies might like the allowance method because it clarifies how much they think they will lose because of bad debts. On the other hand, some people might like the provision method because it shows expected losses as expenses on the income statement.

Why isn’t the direct write off method of uncollectible accounts receivable the preferred method?

The bad debts expense account is debited for the actual amount of the bad debt. This directly impacts both the revenue as well as the outstanding balance due to the company. It causes an inaccuracy in the revenue and outstanding dues for both the accounting period of the original invoice as well as the accounting period of it being classified as a bad debt.

Timing Issues – The Weaknesses of the Direct Write-Off Method

When you employ the allowance technique, you estimate how much bad debt you’ll have to account for over the course of the accounting period. However, it is based on a guess as to which outstanding bills will become bad debts in the long term. Let us consider a sale that was made in the first quarter and then written off in the fourth quarter. When you use the allowance method, you may have correctly estimated the bad debt in the first quarter.

2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches

The percentage you use will depend on the specific factors that affect your business, such as financial data from prior years. For example, if $100,000 of annual revenue relates to sales made on credit, the allowance estimate will equal the percentage chosen multiplied by the $100,000. Alternatively, you may find that applying different percentages to various portions of the AR balance based on the number of days payment is late is more accurate.

However, the direct write-off method must be used for U.S. income tax reporting. Apparently the Internal Revenue Service does not want a company reducing its taxable income by anticipating an estimated amount of bad debts expense (which is what happens when using the allowance method). Generally accepted accounting principles (GAAP) require that companies use the allowance method when preparing financial statements.