Two methods for the accounting of uncollectible accounts is typically used by the businesses â€“ the direct write off method and the allowance method. The direct write off method allows businesses to write off bad debts when they realize that the buyer is not going to make the payment. On the other hand, under the allowance method, businesses are required to make an estimate of their bad debt at the end of the year. Example of write off method – A graphic designer designs a new montage for its customer and then sends him an invoice for $200.
The customer tries avoiding his calls and comes up with different excuses. After a while, the designer realizes that the customer will not be paying ever. So, he debits the bad debts expense account for $200 while crediting the accounts receivable for the same amount. Uncollectible accounts can be deducted from the total taxable amount on a businessâ€™s tax return. The Internal Revenue Service (IRS) requires the companies to go for the direct write off method in order to calculate the amount of these deductions.
Direct Write-Off Method For Uncollectible Accounts and GAAP
Generally Accepted Accounting Principles stands for GAAP, that talks about a set of standard accounting principles that the accountants are required to follow while preparing financial statements. The method of direct-write off doesnâ€™t comply with GAAP.
As per GAAP, the expense account and the revenue account must be matched in the same accounting period. However, under this method, the recording of the uncollectible amount might not be done in the same year as the recording of the invoice.
If the bad debt is accounted for in a different year, it will be recorded against revenue which is completely unrelated to the expense. This will mean that the total revenue will be incorrect in both the accounting years, the year of posting the invoice as well as the year of accounting for uncollectible accounts. This goes against the standards set by GAAP; hence, GAAP doesnâ€™t approve of this method and asks accountants to follow the allowance method for reporting uncollectible accounts or bad debts.
Allowance Method vs. The Direct Write-Off Method
The direct write off method allows the business to write off uncollectible accounts as and when they decide that an invoice will go unpaid. On the other hand, the allowance method asks the businesses to make an estimation of the total amount of uncollectible accounts at the end of the year.
Direct write off method is also comparatively easier as it lets you record the bad debts with just a single journal entry. It is very convenient for owners who donâ€™t have a good accounting background. While the allowance method deals with estimates, the direct write off method records actual losses.
The bad debts account, being an expense, gets debited and the accounts receivable account is credited immediately after an invoice is determined to be uncollectible in the direct write off method. However, in the allowance method, the total amount of uncollectible invoices is estimated at end of the year following which the bad debt expense account is debited while the allowance for doubtful accounts is credited with the estimated amount.
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