What is the Direct write-off method?
The Direct Write-off method is a process of booking the unrecoverable part of receivables that are no longer collectable, by removing that part from the books of accounts without prior booking for the provisions of bad-debts expenses. In other words, it can be said that, whenever a receivable is considered to be unrecoverable, this method fully allows them to book those receivables as an expense without using an allowance account.
The direct write-off method is used only when it is inevitable that a customer will not pay. There is no recording of the estimates or use of allowance for the doubtful accounts under the write-off methods. Bad Debts Expenses for the amount determined will not be paid directly charged to profit and loss account under this method.
The following entry should be passed:-
The write off amount is debited as the expense in the period that it is approved to write off in the income statement. This writes off does not affect the sales performance of the entity in the current period as well as the previous period. It affects only the bottom line of income in the current period. This is because the expenses are recognised in this period. It is probably against the matching principles.
Examples of Direct Write-Off Method
Assume Natalie owns a shop of confectionary. Natalie has many customers who purchase goods from her on credit and pay on account. One of her customers purchased products worth $ 1,500 a year ago, and Natalie still hasn’t been able to collect the payment. After trying to contact the customer number of times, Natalie finally decides that she will never be able to recover these $ 1,500 and decides to write off the balance from such a customer. Using the direct write-off method, Natalie would debit the bad debts expenses account by $ 1,500 and credit the accounts receivable account with the same amount.
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An accounting firm prepares the financial statements of a company as per the laws in force and handover the Financial Statements to its directors in return for a Remuneration of $ 5,000. The remuneration has been outstanding for a year now. The firm is taking regular follow-ups with the Companies directors to which the directors are not responding. Now the partners of the firm decide to write off these receivables of $ 5,000 as Bad Debts not recoverable. The firm then debits the Bad Debts Expenses for $ 5,000 and credits the Accounts Receivables for $ 5,000.
- The main advantage of the Direct Write-off method is that it is straightforward to book and record in books of accounts. Companies only have to pass two journal entries for the amount of the customer’s bad debt.
- The other advantage is that the company can write-off their bad debts on their annual tax returns.
- The contra asset account compilations are also avoided if this method is used.
- There are remote chances of error considering no calculation of estimates of doubtful debts is required. The risk of overstating and understating expenses in the income statements are also minimised.
- Since tax returns are prepared on a cash basis, this method of bad debt expenses is the most appropriate and would save us any extra calculations or work for the preparation of income tax return.
- The major disadvantage of the Direct Write-off method is the possibility of expense manipulation because companies record expenses and revenue in different periods.
- Another disadvantage of direct write-off is that the balance sheet is not an accurate representation of the company’s accounts receivables.
- One more major disadvantage is that it fails to maintain the financial statements as per the generally accepted accounting principle (GAAP).
- A violation of accounting principles means that the financial statements are not portraying an accurate and fair view of the business.
- It goes against the accrual system of accounting and violates the matching principle as well as the prudence concept.
Reasons Why Direct Write-off Method is not preferred in the Accounting Profession?
- The accounts receivable at the end of the financial year would be most likely to be reported in the balance sheet at an amount that is greater than the amount that will actually be received from those receivables.
- The matching principle isn’t followed as the losses from this account is recognized as bad debts or uncollectible, several periods after the income was actually earned.
- The bad debts expenses resulting from the operating activities on credits will appear on the income statement or profit & loss account only after identifying these bad debts accounts and altering them from the company’s accounts receivables.
- The contra asset account compilations are avoided if the direct write-off method is used. No provisions or reporting of provisions are required in this method.
The direct write-off method is the simplest method to book and record the loss on account of uncollectable receivables, but it is not according to the accounting principles. It also makes sure that the loss booked is based on actual figures and not on the appropriation basis. But it violates the accounting principles, GAAP, matching concepts, a true and fair view of the Financial Statements.
Seeing and considering all these points, it is concluded that only being a simple method to record the transaction is not the requirement of an accounting transaction. It must be within the rules and laws framed by the bodies for an accounting of transactions so that a true and correct picture of the Financial Statements can be shown to the stakeholder of the entity. Therefore it is not advised to use the Direct Write-off Method to book for the uncollectable receivables. Instead, the company should look for other methods such as appropriation method and allowance methods for booking of bad debts for its receivables.
This has been a guide to what is the Direct Write-off Method. Here we discuss how it works along with examples, advantages, disadvantages etc. You can learn more about accounting from the following articles –