Direct Write-off and Allowance Methods for Dealing with Bad Debt

But, under the direct write off method, the loss may be recorded in a different accounting period than when the original invoice was posted. When an account is deemed to be uncollectible, the business must remove the receivable from the books and record an expense. This is considered an expense because bad debt is a cost of doing business. Part of the cost of allowing customers to borrow money, which is essentially what a customer is doing when the business allows the customer time to pay, is the expense related to uncollectible receivables. Unlike the allowance method, the company only records bad debt expense when they determine a particular account to be uncollectible. And as the name suggested, bad debt expense will only show up when the company decides to write off any particular accounts.

• If the company estimates that 2% of credit sales will be uncollectible, the current period bad debts expense is $400.
• The direct write off method is a way businesses account for debt can’t be collected from clients, where the Bad Debts Expense account is debited and Accounts Receivable is credited.
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• The direct write-off method offers a straightforward approach to handling bad debts by writing them off as expenses when they are deemed uncollectible.
• However, if the company doesn’t focus on credit sales and only made a few credit sales during the year with only a small balance of receivables, they may use the direct write off method in calculation of bad debt expense.
• The uncollectibility rates above must be based on experiences with customers—it should not be arbitrary.

Generally Accepted Accounting Principles

The contra-asset, Allowance for Doubtful Accounts, is proportional to the balance in the corresponding asset, Accounts Receivable. Every time a business extends payment terms to a customer, that business is taking on risk. The two methods of recording bad debt are 1) direct write-off method and 2) allowance method. Calculate bad debt expense and make adjusting entries at the end of the year. When a specific customer has been identified as an uncollectible account, the following journal entry would occur. The adjusting entries 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.

• For smaller businesses, or those experiencing minimal uncollectible accounts, the simplicity of this method can outweigh its potential drawbacks.
• This method is straightforward because it doesn’t require complex accounting entries or estimates of future bad debts.
• When the estimation is recorded at the end of a period, the following entry occurs.
• There’s no need to predict which accounts will be uncollectible; instead, they write off debts as they become irrecoverable.
• By definition, losses are deductions arising from events that are not normally occurring, such as loss due to fire or inventory theft.

Balance Sheet Aging of Receivables Method for Calculating Bad Debt Expenses

This method provides a more accurate estimate of bad debts and gives a more systematic approach. Suppose a business identifies an amount of 200 due from a customer as irrecoverable as the customer is no longer trading. If the amount is not collectible, it needs to be removed from the customers accounts receivable account, and this is achieved with the following direct write-off method journal entry. We used Accounts Receivable in the calculation, which Bakery Accounting means that the answer would appear on the same statement as Accounts Receivable. Therefore, we have to consider which of our accounts would appear on the balance sheet with Accounts Receivable. Allowance for Doubtful Accounts is a contra-asset account so that is what we calculated.

Is bad debt an expense or loss?

Under the allowance method, a company needs to review their accounts receivable (unpaid invoices) and estimate what amount they won’t be able to collect. This estimated amount is then debited from the account Bad Debts Expense and credited to a contra account called Allowance for Doubtful Accounts, according to the Houston Chronicle. The direct write-off method is easy to operate as it only requires that specific debts are written off with a simple journal as and when they are identified. The problem however, is that under generally accepted accounting principles (GAAP), the method is direct write-off method not acceptable as it violates the matching principle.

Allowance Method

As stated previously, the amount of bad debt under the allowance method is based on either a percentage of sales or a percentage of accounts receivable. When doing the calculations, it is important to understand what the resulting number actually represents. Because one method relates to the income statement (sales) and the other relates to the balance sheet (accounts receivable), the calculated amount is related to the same statement.

Bad debts are uncollectible customer invoices that have already been recorded as revenue. The correct bad debt expense journal entry depends on which method you’re using. The direct write off method is simpler than the allowance method as it takes care of uncollectible accounts with a single journal entry.