What is the Direct Write-off Method and When is it a Good Idea to Use It (3 Cases)Written by Angela on May 10, 2021
Sometimes when you’re a small business owner, freelancer, or sole proprietor, it can be hard to find the time to keep up with all of your bookkeeping. But tracking how much money is coming in and going out of your business is crucial for making smart decisions.
But what happens if you have a client who hasn’t paid you yet–and it looks like they never will? Or you’ve already sold off products but there is an unpaid balance yet to be received?
One way your business can realize any bad debt (that is, uncollected receivables) is through the direct write-off method.
In this article, we’ll discuss what the direct write-off method is and why it might be an attractive option for some businesses. We’ll also share three cases to help you determine when the direct write-off method would work best!
What is the Direct Write-off Method?
The direct write-off method is a common accounting strategy that many small business owners and freelancers use to write off bad debt.
Put simply, with this method, you debit the amount from the Bad Debts Expense account and credit Accounts Receivable. This way, during U.S. income tax reporting season, you can declare the debt and it is written off from your business’s total taxable income.
Do note that the direct write-off method does not comply with the Generally Accepted Accounting Principles (GAAP). This is because bad debts are generally reported several months after the actual sale or service was provided, typically at the end of an accounting period. It can then only be written off at that time. This violates the matching principle, which requires expenses to be reported during the period they were incurred.
Rather, GAAP advocates use of the allowance method, which also handles bad debt in a manner that follows the matching principle.
The Direct Write-off Method vs. the Allowance Method
The allowance method is a type of accounting that handles bad debts in a manner that follows the matching principle. This means it accounts for expenses during the period they were incurred–and not at a later time when an account receivable becomes uncollectible.
To address bad debts under the allowance method, you would review your unpaid invoices at the end of the year (or an accounting period) and estimate how much of these you won’t be able to collect.
You then debit the estimated amount from the account Bad Debts Expense and credited to an account called Allowance for Doubtful Accounts. This is a contra asset account that lessens your Accounts Receivable, and can also be called a Bad Debt Reserve.
Since the direct write-off method violates GAAP, does this mean that the direct write-off method shouldn’t be used?
Pros and Cons of the Direct Write-off Method
Like many things, the direct write-off method does have its benefits and drawbacks.
Let’s go through each one by one so you can decide for yourself if this method is right for your business.
Pro: It’s simple
The direct write-off method is an approach that most small business owners can quickly take advantage of because it only requires two transactions:
- first, to the Bad Debts Expenses account
- second, to Accounts Receivables for the amount your customer owes you
On the other hand, bad debts are reported on an annual basis with the allowance method. This requires some extra calculation on your part, and can be inaccurate over time.
Pro: It’s easier to handle tax write-offs
Yes, the direct write-off method doesn’t follow the GAAP. But the IRS requires businesses to use this method for their tax returns. This is because the allowance method only uses an estimate, and the IRS needs an accurate number in order to calculate your deduction.
If you use the direct write-off method to manage bad debt, you already have that number ready when you file your business’s taxes. Otherwise, you’ll have to go back through your records again to come up with the number.
Pro: It reduces the risk of errors
Since the direct write-off method is based on an actual amount, this will help avoid errors in your financial statements. Chances are less that you’ll overstate or under-report your actual expenses, and everyone wants accurate numbers when it comes to their business, right?
The allowance method, while following the GAAP, is based on an estimate at the end of a financial year. You may get close to the actual amount, but it’s still an estimate.
Con: It violates the matching principle
According to the matching principle, expenses should be reported in the same period they were incurred. But bad debt might not be discovered until the next accounting period, after which it’s too late.
For example, if you perform a service in December and close your books after that, you’ll only realize that your client won’t be paying you in March or even later. The bad debt expense is only recorded then, which means it’s on a different accounting period altogether than from when the revenue was initially recorded.
This can be a problem when you’re trying to forecast and plan for important business projects or even your yearly budget.
Con: It makes your balance sheet inaccurate
Using the direct write-off method, you credit Accounts Receivable during the period you realize the debt. This removes the revenue recorded as well as the outstanding balance owed to the business in the books.
Unfortunately, this will give a false sense of your business’s Accounts Receivable. It will result in an inflated revenue in the previous period, but understated value in the next.
Con: It violates the GAAP
Unfortunately, your financial statements will not give an accurate portrayal of how the business is doing financially if you use the direct write-off method. As previously mentioned, chances are, you’ll be recording your bad debt expense in a different accounting period than when you recorded the revenue.
Depending on how often this happens to your business, you can come across compounded issues when reconciling your accounts and determining your business’s health.
Con: It overstates your accounts receivable
Your business would report the full amount of what your customers owe you when you make a sale or complete a service. But if your customer doesn’t pay you, then the amount reflected in your Accounts Receivables for that period would be too high.
With the allowance method, since you have already planned for a portion of your Accounts Receivables to turn into bad debt, you have a more realistic view of how your business is doing.
Given all of these pros and cons, is there a good reason to use the direct write-off method?
When Should You Use the Direct Write-off Method?
If your business does not regularly deal with bad debt, the direct write-off method might be better suited for you than the allowance method.
As a one-time occurrence, you can deal with managing the inaccuracy of your financial statements, and it is faster and easier to do. The allowance method expects you to keep an ongoing contra asset account which might not be worth your time.
Additionally, if you have little experience with bad debt, any estimates you make may end up very inaccurate.
Therefore, for smaller businesses that deal with simple product sales, the direct write-off method could be the best fit for you. Better yet, you don’t need to worry about coming up with the right number if you need to declare bad debt to the IRS.
However, if you regularly come across bad debt, it might be time to look into the allowance method. This will ensure that your financial statements more accurately reflect the health of your business.
Even if you switch to the allowance method, make sure you track bad debt carefully, so that it’s easier for you to declare the correct value when it’s tax season. Using online software to help you manage your invoices might prove useful, so that you don’t need to go through paper invoices and receipts to determine if you need a tax deduction.
3 Cases to Consider
If you’re still confused how to best use the direct write-off method in your business, consider these next examples to help you determine which method fits your business the best:
Case #1: A bespoke order for a client
Perhaps you have been hired to come up with a bespoke item or even a prototype for a client, for $100. You’ve sent the prototype over for their approval, but soon afterward your client seems to have disappeared.
After a long time, you decide it is uncollectible and record it as a bad debt. In this case, the Accounts Receivables account is reduced by $100 and is recorded as a Bad Debt Expense.
Case #2: A freelancer working on a website project
Let’s say you are a freelance web designer with a website project for $5,000. You record the transaction as a $5,000 credit to your Revenue and $5,000 debit to Accounts Receivables. If you received a downpayment of 50%, you would credit this amount from Accounts Receivables as well.
You finish the website and send your final invoice to your client, but after months of chasing after them, you decide that it is unlikely you’ll ever get paid, so you want to write it off as bad debt.
You credit the Accounts Receivables account with the remaining $2,500 you should have received, and debit the Bad Debt Expense account with the same.
Case #3: Wholesale orders for business clients
If you provide wholesale products to other business clients, you may need to offer them more flexible payment terms. Extending credit to clients can be great for building business relationships. For example, one of your biggest clients has outstanding credit with you for $12,000, as a result of a long-standing business relationship.
Unfortunately, the business goes bankrupt, and they cannot pay the remainder of what they owe you. That means you have bad debt and you need to record it as such.
With the direct write-off method, you would then credit $12,000 from your Accounts Receivables, and debit the same amount to your Bad Debts Expense.
Managing Bad Debt is Important
As you can see, bad debt can have a huge impact on your business. A bad debt of $100 might not look like a big deal for some businesses, and can be easily written off. But if your bad debt amounts to a few thousands, not having accurate reporting and contingency tools can be problematic.
You will have to decide which method works best for your business, based on the advantages and disadvantages of both methods.
To recap, the pros for the direct write-off method include:
- It’s simple.
- It’s easier to handle tax write-offs.
- It reduces the risk of errors.
The cons, however, are:
- It violates the matching principle
- It makes your balance sheet inaccurate
- It violates the GAAP
- It overstates your accounts receivable
For smaller businesses, the simpler direct write-off method may be useful for recording infrequent bad debt incurred.
However, for larger companies or when dealing with bigger amounts, the allowance method may be preferred to manage bad debt risk and accurately report the health of the company.
Nobody likes bad debt, and you can help mitigate the risk by keeping careful track of your invoices and payments with online invoicing software like InvoiceBerry.
However, you may still have to deal with bad debt sooner or later. With this information, you can better prepare your business and sail through the challenge easily.