For example, one of your biggest clients has outstanding credit with you for $12,000, as a result of a long-standing business relationship. Therefore, for smaller businesses that deal with simple product sales, the direct write-off method could be the best fit for you. Better yet, you don’t need to worry about coming up with the right number if you need to declare bad debt to the IRS. The direct write-off method is a common accounting strategy that many small business owners and freelancers use to write off bad debt.

  • Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $150.
  • Once this account is identified as uncollectible, the business will record a reduction to the customer’s accounts receivable and an increase to bad debt expense for the exact amount uncollectible.
  • 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.
  • Also note that it is a requirement that the estimation approach be disclosed in the notes of financial statements so stakeholders can make informed decisions.

This way, during U.S. income tax reporting season, you can declare the debt and it is written off from your business’s total taxable income. If you use the direct write off method for this invoice, the revenue for the first quarter would be artificially higher. This skews the actual revenue of the company in these two time periods and causes the related financial reports to be inaccurate. Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $48,727.50 ($324,850 × 15%). Let’s consider that BWW had a $23,000 credit balance from the previous period. The following table reflects how the relationship would be reflected in the current (short-term) section of the company’s Balance Sheet.

Direct Write-Off and Allowance Methods

Thus, the revenue amount remains the same, the remaining receivable is eliminated, and an expense is created in the amount of the bad debt. The direct write off method involves charging bad debts to expense only when individual invoices have been identified as uncollectible. 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.

It’s certainly easier for small business owners with no accounting background. It also deals in actual losses instead of initial estimates, which can be less confusing. This means that when the loss is reported as an expense in the books, it’s being stacked up on the income statement against revenue that’s unrelated to that project.

If Beth later receives the payment from the customer, she can reverse the write off journal entry by crediting bad debt and debiting accounts receivable. Beth can then record the receipt of the cash with a debit to cash and a credit to accounts receivable. The direct write-off method is a simple process, where you would record a journal entry to debit your bad debt account for the bad debt and credit your accounts receivable account for the same amount.

Continuing our examination of the balance sheet method, assume that BWW’s end-of-year accounts receivable balance totaled $324,850. This entry assumes a zero balance in Allowance for Doubtful Accounts from the prior period. BWW estimates 15% of its overall accounts receivable will result in bad debt. In this scenario, $600 would be credited to your company’s revenue, while $600 would be debited from accounts receivable. You realise after a few months of attempting to collect on the $600 invoice that you will not be paid for your services. 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.

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Now total revenue isn’t correct in either the period the invoice was recorded or when the bad debt was expensed. The direct write off method may be necessary to maintain the accuracy of the written off amount. However, it creates inaccuracies in the revenue and bad debt amounts that are reflected in the financial reports. The generally accepted accounting principles or GAAP require that all revenue costs must be expensed in the same accounting period. When you file a business tax return, you can write off bad debts from the total taxable income. It is mandatory to use the direct write off method for IRS tax returns and the allowance method is not accurate enough.

Fundamentals of Bad Debt Expenses and Allowances for Doubtful Accounts

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. The understanding is that the couple will make payments each month toward the principal borrowed, plus interest. On the income statements, the allowance approach is utilised to account for bad debts.

Advantages of the Direct Write-Off Method

Let’s consider a situation where BWW had a $20,000 debit balance from the previous period. If Wayne allows this entry to remain on his books, his accounts receivable balance will be overstated by $500, since Wayne knows that it’s not collectible. If you offer credit terms to your customers, you’ll have at least a few bad debt accounts.

Estimating Allowance Account

Therefore the entire balance in Accounts Receivable will be reported as a current asset on the company’s balance sheet. As a result, the balance sheet is likely to report an amount that is greater than the amount that will actually be collected. It can also result in the Bad Debts Expense being reported on the income statement in the year after the year of the sale. For these reasons, the accounting profession does not allow the direct write-off method for financial reporting. Usually many months will pass between the time of the sale on credit and the time that the seller knows with certainty that a customer is not going to pay. It is difficult to adhere to the matching principle and the concept of conservatism when a significant amount of time elapses between the time of the sales revenues and the time that the bad debts expense is reported.

Tax Deduction for Uncollected Judgments

For example, a category might consist of accounts receivable that is 0–30 days past due and is assigned an uncollectible percentage of 6%. Another category might be 31–60 days past due and is assigned an uncollectible percentage of 15%. All categories of estimated uncollectible amounts are summed to get a total estimated uncollectible balance.