Net Accounts Receivable: Direct Write-off Method - Online Tutor, Practice Problems & Exam Prep

When extending credit, businesses face the risk of bad debt expense, which arises when customers fail to pay. The direct write-off method records bad debt expense when an account is deemed uncollectible, violating the matching principle of GAAP. For example, if a company sells on credit and later identifies an account as uncollectible, it debits bad debt expense and credits accounts receivable. This method is straightforward but not compliant with GAAP, as it mismatches revenue and expenses across accounting periods.

Net Accounts Receivable: Direct Write-off Method

Alright. When we extend credit to our customers, there's a chance that we won't get paid, right? So let's see what happens in those situations. If we allow our customers to pay us later, there might be a chance that we will not get paid, right? So we're going to have what's called bad debt expense, right? We're extending this credit to our customers and they don't pay us back. Well, that's bad debt. These are losses that result from extending credit but not getting paid. That's the bad debt expense.

The first method we're going to talk about is the direct write-off method, and I want to go right away and tell you that this is not GAAP. This method is not GAAP, but it's simple to use. So this is why we explain it first. Basically, with the direct write-off, we're going to take a bad debt expense as soon as the company decides that they're not going to collect on that account. So if they say, hey, this customer doesn't look like they're ever going to pay us, right then we take the bad debt expense. But let's see why this would not be GAAP. This method does not follow the matching principle. We have the matching principle. If you remember, the matching principle tells us that we have to match our expenses with our revenues. When we earn revenue, what did it take us to earn that revenue? Those were the expenses that we had to take on. And we want to make sure that when we earn the revenue, we take the expenses in the same period. So let's see how this affects our bad debt expense entry.

In year 1, we could have some credit sales. In the keyword credit, meaning that we sold it on account, they're going to pay us later, so we would debit accounts receivable for whatever amount, and we would credit revenue. Notice we're taking revenue in year 1 in this case. However, it takes us until February of year 2. Now we're in year 2 and we're like, you know what? I don't think we're going to collect on some of these accounts. Let's write off those accounts and then we make some sort of entry in year 2. In year 1, we took the revenue, but now in year 2, when we decide, okay, we're not going to get this money back, now we're going to take the expense, bad debt expense, in year 2 and then we're going to credit our accounts receivable to get rid of that account. We said, hey, we're not going to collect this account, so we credit it to get rid of the account receivable and we take the bad debt expense. But notice the problem with this and why it's not GAAP, we're taking bad debt expense in year 2 and we're taking revenue in year 1. That bad debt expense that we took in year 2, it's related to year 1 sales. So we should've taken that bad debt expense in year 1.

And we'll learn more about how to do this properly, but they do love to test you on the direct write-off method as well. So let's go ahead and do an example here. A company sold items on account to 3 customers. Quick Quinn owes $150, Slow Joe owes $3.50, and Sketchy Jack owes 500. Quinn paid after 2 days, Joe paid after 6 weeks, and Sketchy Jack has not still not paid the company, and the company has lost contact with Jack. That doesn't sound very good. It tells us here the company deemed his account uncollectible, so journalize these transactions. At first, we make our sales to these 3 people. When we make a sale, we're going to debit accounts receivable because he's going to pay us later. Right? So we're debiting it 150, and we're going to credit and this is Quick Quinn. Quick Quinn owes 1 50, and we would credit revenue for 150. So let's do it 1 at a time. So that would be Quinn's revenue entry, we got the revenue, and how about when Quinn pays us? Well, he pays us 2 days later, easy enough. We got cash of $1.50 when he paid us and we got rid of the accounts receivable with a credit. He no longer owes us that money.

Now let's look at Slow Joe. It's going to be very similar, actually, almost identical other than the numbers. So we're going to take our AR and our revenue entries, $3.50 for Slow Joe and it's going to be the same thing here. He paid us in cash, it just took him a little longer, but notice this doesn't change the entries. Just because he took longer to pay us, these are still the entries that get made. But now let's go on to Sketchy Jack. At first, we sold the stuff to Sketchy Jack, and we maybe only knew him as Jack. We didn't know he was Sketchy Jack, and this is what we find out. So at first, we sell it to him and we make our standard revenue entry for the $500. He took $500 worth of stuff, so we're expecting to receive $500 for it, and then later on, we realize he's not going to pay us. At that point when we realize he's not going to pay us, what we're going to make an entry for bad debt expense. Right? Our expenses go up with debits for the 500, and we're going to credit accounts receivable in this case for the 500. And that gets rid of the account receivable and it creates a bad debt expense that's going to go to the income statement. But again, remember this is not GAAP. Let's just write it down here nice and big, not GAAP. Alright. Cool. Let's go ahead and move on to the other methods and let's see what GAAP prescribes.

Here’s what students ask on this topic:

What is the direct write-off method in accounting?

The direct write-off method in accounting is a way to handle bad debt expenses. When a company determines that a specific account receivable is uncollectible, it directly writes off the amount by debiting bad debt expense and crediting accounts receivable. This method is straightforward but does not comply with Generally Accepted Accounting Principles (GAAP) because it violates the matching principle. The matching principle requires that expenses be recorded in the same period as the related revenues, but the direct write-off method often records bad debt expense in a different period than the revenue was earned.

Why is the direct write-off method not GAAP compliant?

The direct write-off method is not GAAP compliant because it violates the matching principle. The matching principle requires that expenses be recorded in the same period as the revenues they help generate. In the direct write-off method, bad debt expense is recorded only when an account is deemed uncollectible, which may occur in a different accounting period than when the related revenue was recorded. This mismatch can distort financial statements, making it difficult to accurately assess a company's financial performance and position.

How does the direct write-off method affect financial statements?

The direct write-off method affects financial statements by potentially distorting the timing of expense recognition. When bad debt expense is recorded in a different period than the related revenue, it can lead to an overstatement of net income in the period when the revenue is recognized and an understatement in the period when the bad debt is written off. This mismatch can make it challenging to accurately assess a company's profitability and financial health, as expenses are not properly matched with the revenues they helped generate.

Can you provide an example of the direct write-off method?

Sure! Let's say a company sells $500 worth of goods on credit to a customer named Sketchy Jack. Initially, the company debits accounts receivable and credits revenue for $500. Later, the company realizes that Sketchy Jack will not pay the amount owed. At this point, the company debits bad debt expense and credits accounts receivable for $500. This entry removes the uncollectible account from the books and records the bad debt expense. However, this method does not comply with GAAP because the bad debt expense is recorded in a different period than the revenue, violating the matching principle.

What are the advantages and disadvantages of the direct write-off method?

The main advantage of the direct write-off method is its simplicity. It is straightforward to implement and requires fewer accounting entries. However, the disadvantages include non-compliance with GAAP and the potential for distorted financial statements. By not adhering to the matching principle, this method can lead to inaccurate representations of a company's financial performance and position, making it difficult for stakeholders to make informed decisions.