Uncollectible accounts receivable can trip up even the most seasoned professionals. These outstanding balances represent real challenges, potential risks, and missed opportunities. It’s essential accounting tools definition to check the financial health and reputation of a prospective client before entering a business relationship.

Generally Accepted Accounting Principles

The income statement method (also known as the percentage of sales method) estimates bad debt expenses based on the assumption that at the end of the period, a certain percentage of sales during the period will not be collected. The estimation is typically based on credit sales only, not total sales (which include cash sales). In this example, assume that any credit card sales statement of changes in equity that are uncollectible are the responsibility of the credit card company. It may be obvious intuitively, but, by definition, a cash sale cannot become a bad debt, assuming that the cash payment did not entail counterfeit currency.

However, it’s wise to reconsider your approach if it’s been several months or even a year with no promise of payment. It’s important to realize that not every unpaid invoice warrants a date in court. If the amount owed surpasses a particular figure, which severely impacts your business, it may be time to involve legal counsel. We need to distinguish between bad debt and uncollectible accounts before venturing any further.

We record Bad Debt Expense for the amount we determine will not be paid. This method violates the GAAP matching principle of revenues and expenses recorded in the same period. 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).

1. The balance sheet aging of receivables method estimates bad debt expenses based on the balance in accounts receivable, but it also considers the uncollectible time period for each account.
2. We do not record any estimates or use the Allowance for Doubtful Accounts under the direct write-off method.
3. It is important to consider other issues in the treatment of bad debts.
4. The direct write off method violates GAAP, the generally accepted accounting principles.
5. This estimated amount is then debited from the account Bad Debts Expense and credited to a contra account called Allowance for Doubtful Accounts, according to the Houston Chronicle.

Enhance Credit Policies by Tightening Your Credit Approval Process

The direct write-off method is easy to operate as it only requires that specific debts are written off with a simple journal as and when they are identified. The problem however, is that under generally accepted accounting principles (GAAP), the method is not acceptable as it violates the matching principle. Under the allowance method, a company needs to review their accounts receivable (unpaid invoices) and estimate what amount they won’t be able to collect.

These are not yet recognized as expenses, as you’re still clinging to the hope of being collected. These too might transition into bad debts over time if efforts remain unsuccessful. The direct write off method violates GAAP, the generally accepted accounting principles. GAAP says that all recorded revenue costs must be expensed in the same accounting period. This is called the matching principle, according to Accounting Tools. Under the direct write off method, when a small business determines an invoice is uncollectible they can debit the Bad Debts Expense account and credit Accounts Receivable immediately.

Module 6: Receivables and Revenue

Thus, the profit in the initial month is overstated, while profit is understated in the month when the bad debts are finally charged to expense. The alternative to the direct write off method is to create a provision for bad debts in the same period that you recognize revenue, which is based upon an estimate of what bad debts will be. This approach matches revenues with expenses, so that all aspects of a sale are included within a single reporting period. Conversely, the direct write-off method might involve a delay of several months between the initial sale and a charge to bad debt expense, which does not provide a complete view of a transaction within one reporting period. Therefore, the allowance method is considered the more acceptable accounting method.

Client bankruptcy is one of the primary reasons for uncollectibility. Filing for bankruptcy typically means the client is legally unable to fulfill their debt obligations. It’s essentially revenue you counted on but will probably never materialize. You already incurred costs of delivering a product or service, which makes matters worse.

Balance Sheet Aging of Receivables Method for Calculating Bad Debt Expenses

The direct write-off method recognizes bad accounts as an expense at the point when judged to be uncollectible and is the required method for federal income tax purposes. The allowance method provides in advance for uncollectible accounts think of as setting aside money in a reserve account. The allowance method represents the accrual basis of accounting and is the accepted method to record uncollectible accounts for financial accounting purposes. For example, a company may recognize $1 million in sales in one period, and then wait three or four months to collect all of the related accounts receivable, before finally charging some bad debts off to expense. This creates a lengthy delay between revenue recognition and the recognition of expenses that are directly related to that revenue.

But the allowance method is more commonly preferred and often used by larger companies and businesses frequently handling receivables. If you’re wondering which method is best for your small business, speak with a professional for insights into your specific situation. You may notice that all three methods use the same accounts for the adjusting entry; only the method changes the financial outcome.

Allowance for doubtful accounts decreases because the bad debt amount is no longer unclear. Accounts receivable decreases because there is an assumption that no debt will be collected on the identified customer’s account. As you’ve learned, the delayed recognition of bad debt violates GAAP, specifically the matching principle. Therefore, the direct write-off method is not used for publicly traded company reporting; the allowance method is used instead. Notice how we do not use bad debts expense in a write-off under the allowance method. But, the write off method allows revenue to be expensed whenever a business decides an invoice won’t be paid.

Direct Write-Off Method vs. Allowance Method

This eliminates the revenue recorded as well as the outstanding balance owed to the business in the books. The direct write off method is simpler than the allowance method as it takes care of uncollectible accounts with a single journal entry. It’s certainly easier for small business owners with no accounting background. It also deals in actual losses instead of initial estimates, which can be less confusing. The direct write-off method delays recognition of bad debt until the specific customer accounts receivable is identified.