What Is the Direct Write-Off Method? Definition and How it Works
Updated June 24, 2022
Using the direct write-off method is an effective way for your business to recognize any bad debt. Bad debt refers to debt that customers owe for a good or service but won't be paying back. In other words, it's money they need to pay for a sale or service that they won't be paying and the company won't be receiving. Another way to refer to this is uncollectible receivables. Using the direct write-off method can help your business easily manage bad debt if you rarely get uncollected payments. In this article, you'll learn how to use the direct write-off method for your business and potential advantages and disadvantages of direct write-off.
What is the direct write-off method?
The direct write-off method is an accounting method by which uncollectible accounts receivable are written off as bad debt. In essence, the bad debts expense account is debited and accounts receivable is credited. This method is required for U.S. income tax reporting and should not be confused with the allowance method, which also accounts for bad debt.
It's also important to note that the direct write-off method violates the matching principle, which states that expenses should be reported during the period in which they were incurred. This is because with the direct write-off method, a bad debt is reported when the accounts receivable is written off. This process could take several months after the initial sale was made.
In the event that a customer decides to pay what they owe later on, the accounts receivable account would be debited and the bad debt expense would be reduced.
Advantages of the direct write-off method
When owning a business, it's important to understand not only the direct write-off method but its advantages, as well. Here are some of the advantages of using this method:
The direct write-off method is considered an easy way to deal with bad debts because you only need to make two transactions—one to the bad debts expenses account and the other to accounts receivable for the amount the customer owes. In contrast, the allowance method requires you to report bad debt expenses every fiscal year.
2. Tax write-off
Companies with bad debt can write it off on their annual tax returns. This is because although the direct write-off method doesn't follow the Generally Accepted Accounting Principles (GAAP), the IRS requires companies to use this method for their tax returns. In other words, bad debt expenses can be written off from a company's taxable income on their tax return. The inaccuracy of the allowance method can't be utilized under these circumstances because the IRS needs an accurate way to calculate a deduction.
3. It's based on an actual amount
Whereas management estimates the write-off in the allowance method, the direct write-off method is based on an actual amount. The direct write-off method avoids any errors in this regard and also reduces the risk for overstating or understanding any expenses.
Disadvantages of the direct write-off method
Though the direct write-off method can be helpful for businesses, it also has many drawbacks. Here are some disadvantages of using the direct write-off method:
1. Violates the matching principle
As mentioned above, the use of the direct write-off method violates the matching principle. This is because according to the matching principle, expenses need to be reported in the same period in which they were incurred. With the direct write-off method, however, bad expenses might not be realized to be bad expenses until the following period. For example, if you made a sale at the end of one accounting period ending in December, you might not realize the bad debts until the beginning of March. A direct write-off often happens in a different year than when the sale was made, or in other words, the revenue was recorded by your business.
2. Balance sheet inaccuracy
Another disadvantage of the direct write-off method regards the balance sheet. Since using the direct write-off method means crediting accounts receivable, it gives a false sense of a company's accounts receivable.
3. Violates GAAP
Using the direct write-off method also violates the GAAP because of how it records things on the balance sheet. Financial statements are not giving an accurate portrayal of how the business is doing financially.
4. Overstates accounts receivable
Using the direct write-off method, your business reports the full amount of what customers owe when a credit sale is made. This is referred to as accounts receivable. But if your company were to have uncollectible accounts receivable, the amount in accounts receivable would be too high.
Related: Learn About Being an Accountant
Here are some examples of the direct write-off method in action:
Let's say a woodworker created a rocking chair for your family and sent you an invoice for $300. When the woodworker doesn't hear back from your family about paying the invoice, they decide your family doesn't plan on paying. Under these circumstances, the woodworker would debit the bad debt expense account for $300 and credit the accounts receivable account for $300.
You own a car auto shop and install a new engine in a customer's car for $3,000. After attempting to contact the customer for the invoice of $3,000, you have yet to hear back for months. After this time, you deem it uncollectible and record it as a bad debt. In this case, the accounts receivable account is reduced by $3,000 and is recorded as a bad debt expense.
Let's say you made a cake for a couple's wedding for $600. You then send them an invoice of $600 after finishing the cake. In this case, $600 would be a credit entry to your company's revenue and a debit entry of $600 would be made to accounts receivable. After a few months of trying to collect on the $600 invoice, you come to the realization that you won't be paid for your services. Using the direct write-off method, a debit to the bad debt expense account for $600 will be made and a credit of $600 to accounts receivable will be made. This would reverse the first transaction.
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