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
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.
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: 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.
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. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
