Why allowance method of accounting for doubtful debt is better than the direct method?

What happens when a customer doesn’t pay for products or services? The business is left out of pocket with “bad debt” to balance in the books. The direct write off method offers a way to deal with this for accounting purposes, but it comes with some pros and cons.

What is the direct write off method?

To better understand the answer to “what is the direct write off method,” it’s first important to look at the concept of “bad debt”. Bad debt refers to any amount owed by a customer that will not be paid. The direct write off method of accounting for bad debts allows businesses to reconcile these amounts in financial statements.

To apply the direct write off method, the business records the debt in two accounts:

• Bad Debts Expenses as a debit

• Accounts Receivable as a credit

As a direct write off method example, imagine that a business submits an invoice for $500 to a client, but months have gone by and the client still hasn’t paid. At some point the business might decide that this debt will never be paid, so it would debit the Bad Debts Expense account for $500, and apply this same $500 as a credit to Accounts Receivable.

The IRS allows bad debts to be written off as a deduction from total taxable income, so it’s important to keep track of these unpaid invoices in one way or another. It’s also important to note that unpaid invoices are categorized as assets, which are debited in accounting.

In the direct write off method example above, what happens if the client does end up paying later on? Both charges would be reversed. Accounts Receivable would be debited, and the Bad Debt Expense account would be reduced.

Direct write off method GAAP compliance

One issue that immediately crops up when it comes to this method is that of direct write off method GAAP compliance. The direct write off method doesn’t comply with the GAAP, or generally accepted accounting principles.

GAAP states that expenses and revenue must be matched within the same accounting period. However, the direct write off method allows losses to be recorded in different periods from the original invoice dates. This means that reported losses could appear on the income statement against unrelated revenue, which distorts the balance sheet. It will report more revenue than might have actually been generated.

As a result, although the IRS allows businesses to use the direct write off method for tax purposes, GAAP requires the allowance method for financial statements.

Direct write off method vs. the allowance method

The allowance method offers an alternative to the direct write off method of accounting for bad debts. With the allowance method, the business can estimate its bad debt at the end of the financial year. Rather than writing off bad debt as unpaid invoices come in, the amount is tallied up only at the end of the accounting year.

The estimated amount is debited from the Bad Debts Expense and credited to an Allowance for Doubtful Accounts to maintain balance.

Direct write off method advantages

There are several advantages to using the direct write off method:

1. Straightforward procedure: The direct write off method offers a simple way to deal with unpaid debts. You only need to list two transactions for each unpaid invoice, with greater flexibility on timings.

2. Tax deductions: You can write off your bad debt on annual tax returns, according to the IRS. By contrast, the IRS won’t accept bad debts written off using the allowance method, because it uses estimates rather than precise figures.

3. Precision: Because it’s based on factual amounts gleaned directly from invoices, the direct write off method prevents errors in your financial reporting.

Direct write off method disadvantages

At the same time, there are some disadvantages to be aware of:

1. It goes against the matching principle: According to the matching principle in accounting, expenses must be reported in the same period that they were incurred. Bad expenses might not be recognized until later on with the direct write-off method, which would lead to a mismatch.

2. It can cause inaccuracy: The mismatch in timings mentioned above could also cause an inaccuracy in your business’s balance sheet. Crediting the accounts receivable could overstate profit.

3. It causes GAAP violations: The GAAP doesn’t allow use of the direct write off method because of these inaccuracies. Financial statements might not accurately reflect a business’s true financial standing.

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