Why is the allowance method preferred over the direct write-off method of accounting for bad debts

Bad debt, or the inability to collect money owed to you, is an unfortunate reality that small business owners must occasionally deal with. You’ll need to decide how you want to record this uncollectible money in your bookkeeping practices. 

Find out more about the direct write-off method, how to use it, and compare the direct write-off method and the allowance method. Then make sure you understand the limitations of the direct write-off method

Key Takeaways

• The direct write-off method is an accounting method used to record bad debt.
• When using this method, businesses wait until a debt is determined uncollectible before marking it as such in their records. A bad debt account is debited for the uncollectible amount and that same amount is credited to accounts receivable.
• While there are some scenarios in which the direct write-off method makes more sense, the allowance method—another accounting method that businesses can use to handle bad debt—is generally considered the more acceptable practice.

What Is the Direct Write-Off Method?

The direct write-off method is a way for businesses to record bad debt. When using this accounting method, a business will wait until a debt is deemed unable to be collected before identifying the transaction in the books as bad debt. 

To keep the business’s books accurate, the direct write-off method debits a bad debt account for the uncollectible amount and credits that same amount to accounts receivable. It removes any expectation that the funds will be received.

Note

Bad debts in business commonly come from credit sales to customers or products sold and services performed that have yet to be paid for. 

How To Use the Direct Write-Off Method

After determining a debt to be uncollectible, businesses can use the direct write-off method to ensure records are accurate. 

We’ll use the example of a machine shop that sells to customers on credit. Let’s say that the business fulfills an order of $1,000 worth of parts. Despite multiple attempts to contact the customer, it seems the customer doesn’t plan to pay for the products. The shop marks the bad debt in their books by moving the uncollectible amount out of accounts receivables, and into a bad debt account. For example:

If the customer suddenly appears a few months later and pays off their debt, the machine shop can reverse the transaction in their books using the following method:

They can then record the payment as follows:

Direct Write-Off Method vs. Allowance Method

The two accounting methods used to handle bad debt are the direct write-off method and the allowance method. While the direct write-off method doesn’t label a transaction as bad debt until it’s deemed uncollectible, the allowance method estimates ahead of time how much bad debt the business anticipates and records it in the sale period. 

The direct write-off method doesn’t adhere to the expense matching principle—an expense must be recognized during the same period that the revenue is brought in. As a result, the direct write-off method violates the generally accepted accounting principles (GAAP). The GAAP requires the use of the allowance method.

Limitations of the Direct Write-Off Method

The allowance method is the more generally accepted method due to the direct write-off method’s limitations.

The direct write-off method waits until an amount is determined to be uncollectible before identifying it in the books as bad debt. Reporting revenue and expenses in different periods can make it difficult to pair sales and expenses and assets and net income can be overstated. 

Note

Businesses can only take a bad debt tax deduction in certain situations, usually using what’s called the “charge-off method.” Read more in IRS Publication 535, Business Expenses.

The Bottom Line

If you’re a small business owner who doesn’t regularly deal with bad debt, the direct write-off method might be simpler. But the allowance method is more commonly preferred and often used by larger companies and businesses frequently handling receivables. The allowance method adheres to the GAAP. If you’re wondering which method is best for your small business, speak with a professional for insights into your specific situation.

Frequently Asked Questions (FAQs)

When does it make sense to use the direct write-off method?

The direct write-off method can be a useful option for small businesses infrequently dealing with bad debt or if the uncollectibles are for a small amount.

Why is the allowance method typically preferred over the direct write-off method?

Big businesses and companies that regularly deal with lots of receivables tend to use the allowance method for recording bad debt. The allowance method adheres to the GAAP and reports estimates of bad debt expenses within the same period as sales.

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