Businesses that sell their goods and services to customers on credit inevitability have to deal with bad debts. Some customers will never pay the money they owe to a company. Companies take measures to recover the money customers owe. When they are not successful, they consider the accounts uncollectible. Companies account for uncollectible accounts using two methods – the direct write-off method and the allowance method.
Direct Write-off Method
Companies use the direct write-off method when they decide there is no chance of receiving the money that a customer owes. Companies should exhaust all recovery attempts before writing off a bad debt. To write a debt off, companies debit the bad debt expense account and credit the accounts receivable account. The Internal Revenue Service requires the direct write-off method, although it does not conform to generally accepted accounting principles (GAAP).
Pros and Cons of Direct Write-off Method
An advantage of using the direct write-off method is that it is simple. Companies only have to make two transactions for the amount of the customer’s bad debt. Another advantage is that companies can write off their bad debt on their annual tax returns. A disadvantage of the direct write-off method is the possibility of expense manipulation, because companies record expenses and revenue in different periods. Therefore, companies should only use this method for small amounts that do not significantly impact financial records. Another disadvantage is that the balance sheet is not an accurate representation of the company’s accounts receivable.
Management uses the allowance for doubtful accounts method to estimate credit accounts that customers will not pay. Companies don't immediately write off accounts. Instead, management uses past financial information to estimate bad debt amounts. The first journal entries under the allowance method include a debit to bad debt expense and a credit to allowance for doubtful accounts. When the company considers an account to be completely uncollectible, it makes a debit to allowance for doubtful accounts and a credit to accounts receivable.
Pros and Cons of Allowance Method
An advantage of the allowance method is that it follows the matching principle, which allows for accurate financial records. Another advantage is that the balance sheet accurately reports accounts receivable, which benefits investors and management. A disadvantage is that management might inaccurately estimate write-offs by a large margin, which can cause companies to misstate net income.