It is a matter of judgment, relating only to the conclusion that the choice among alternatives really has very little bearing on the reported outcomes. In the direct write-off method, bad debts are expensed out when
they occur and are not related to the sales for the year. The direct write-off methods violate the matching principle of accounting which states that every expense booked for the year should match the revenue it has generated. After analysing all of these factors, it is decided that just recording a transaction is not a condition of an accounting transaction. It must follow the norms and legislation established by the organisations for transaction accounting in order to present a true and accurate image of the financial statements to the entity’s stakeholders. Costs and revenue must match throughout the entire accounting period, according to GAAP.

Whether you have accounting or bookkeeping experience, our easy-to-use software records all your transactions automatically in the correct accounts. As well, all accounting data from the software’s subledgers are transferred to the general ledger. Although only publicly held companies must abide by GAAP rules, it is still worth considering the implications of knowingly violating GAAP. Because write-offs frequently occur in a different year than the original transaction, it violates the matching principle; one of 10 GAAP rules. While it’s not recommended for regular use, if your business seldom has bad debt, it can be a quick, convenient way to remove bad debt from your books.

What Is Wrong with the Direct Write off Method?

Net realizable value is the amount the company expects to collect from accounts receivable. When the firm makes the bad debts adjusting entry, it does not know which specific accounts will become uncollectible. Thus, the company cannot enter credits in either the Accounts Receivable control account or the customers’ accounts receivable subsidiary ledger accounts. If only one or the other were credited, the Accounts Receivable control account balance would not agree with the total of the balances in the accounts receivable subsidiary ledger. Without crediting the Accounts Receivable control account, the allowance account lets the company show that some of its accounts receivable are probably uncollectible. So, an uncollected account is debited from the bad debts expense account and credited to the allowance for doubtful accounts in the same accounting period as the original sale.

After attempting to contact the customer for the invoice of $3,000, you have yet to hear back for months. In this case, the accounts receivable account is reduced by $3,000 and is recorded as a bad debt expense. This means that when the loss is reported as an expense in the books, it’s being stacked up on the income statement against the revenue that’s unrelated to that project. The journal entry for the Bad Debt Expense increases (debit) the expense’s balance, and the Allowance for Doubtful Accounts increases (credit) the balance in the Allowance.

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

Skynova gives you the means to resolve bad debt with good business practices. In deciding which method to use to account for bad debt, you need to understand the benefits and disadvantages of the direct write-off method. Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent.

Using the direct write-off technique, a debit of $600 will be recorded to the bad debt expense account, and a credit of $600 will be made to accounts receivable. The real amount of the bad debt is deducted from the bad debt expense account. This has a direct influence on sales as well as the company’s outstanding balance. It results in inaccuracies in revenue and outstanding dues for both the initial invoice accounting period and the accounting period after it is designated as a bad debt.

Financial Accounting

That is, costs related to the production of revenue are reported during the same time period as the related revenue (i.e., “matched”). Hence, the bad debt expense recorded each year is matched to the net sales for the year as per the matching principle of accounting. At the end of an accounting period, the Allowance for Doubtful Accounts reduces the Accounts Receivable to produce Net Accounts Receivable. Note that allowance for doubtful accounts reduces the overall accounts receivable account, not a specific accounts receivable assigned to a customer. Because it is an estimation, it means the exact account that is (or will become) uncollectible is not yet known.

• Bad debt, or the inability to collect money owed to you, is an unfortunate reality that small business owners must occasionally deal with.
• Note that allowance for doubtful accounts reduces the overall accounts receivable account, not a specific accounts receivable assigned to a customer.
• However, the company is owed $90,000 and will still try to collect the entire $90,000 and not just the $85,200.
• If you’re wondering which method is best for your small business, speak with a professional for insights into your specific situation.
• While the direct write-off method is the easiest way to eliminate bad debt, it should be used infrequently and with caution.