The balance sheet method (also known as the percentage of accounts receivable method) estimates bad debt expenses based on the balance in accounts receivable. The method looks at the balance of accounts receivable at the end of the period and assumes that a certain amount will not be collected. Accounts receivable is reported on the balance sheet; thus, it is called the balance sheet method. The balance sheet method is another simple method for calculating bad debt, but it too does not consider how long a debt has been outstanding and the role that plays in debt recovery. As the accountant for a large publicly traded food company, you are considering whether or not you need to change your bad debt estimation method.

  • This requires some extra calculation on your part, and can be inaccurate over time.
  • If Ariel gets payment from the customer later, she can credit bad debt and debit accounts receivable to reverse the write-off journal entry.
  • It is a matter of judgment, relating only to the conclusion that the choice among alternatives really has very little bearing on the reported outcomes.
  • The business is left out of pocket with “bad debt” to balance in the books.

When preparing financial statements, the allowance technique must be employed. In addition, under the percentage of credit sales approach, we ignore any existing balance in the allowance when calculating the amount of the year-end adjustment. For example, assume Kenco makes a $5000 credit sale to Bennards on 28th March. On 30th August, Kenco Ltd determines that it will be unable to collect from Bennards. When the account defaults for non-payment on 30th August, Kenco would record the following journal entry to recognise bad debt. When using this accounting method, a business will wait until a debt is deemed unable to be collected before identifying the transaction in the books as bad debt.

Direct Write-Off Method vs. Allowance Method

The allowance method is used to allow for bad debts on the income statements. Since the allowance method uses an estimated amount, it is not as accurate as of the direct write off method. In the direct write off method, the bad debts expense account is debited and the accounts receivable is credited. This is the opposite of the usual practice of an unpaid invoice being a debit in the accounts receivable account.

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. The direct write-off method is a common accounting strategy that many small business owners and freelancers use to write off bad debt.

  • If an account is more than six months old, the likelihood increases that you won’t collect the debt without a collection agency or lawsuit.
  • This is a distortion that reflects on the revenue financial reports for the accounting period of the original invoice as well as the period of the write off.
  • Your small business bookkeeper or accountant needs to manage bad debt properly.
  • The second entry records the payment in full with Cash increasing (debit) and Accounts Receivable decreasing (credit) for the amount received of $15,000.
  • Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $150.
  • The two accounting methods used to handle bad debt are the direct write-off method and the allowance method.

This approach estimates bad debt expenses based on the balance in accounts receivable, but it also considers the uncollectible time period for each account. For example, when a business accounts for bad debt expenses in their financial statements, it will use an accrual-based method; however, they are required to use the direct write-off method on their income tax returns. This variance in treatment addresses taxpayers’ potential to manipulate when a bad debt is recognised. Net realizable value is the amount the company expects to collect from accounts receivable.

3: Direct Write-Off and Allowance Methods

Generally accepted accounting principles, commonly called GAAP, provide rules for guidance and standards in recording and reporting financial information. GAAP rules come from the Securities and Exchange Commission and the accounting profession. Because customers do not always keep their promises to pay, companies must provide for these uncollectible accounts in their records. 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.

Accounting for the Direct Write-Off Method

Another category might be 31–60 days past due and is assigned an uncollectible percentage of 15%. All categories of estimated uncollectible amounts are summed to get a total estimated uncollectible balance. That total is reported in Bad Debt Expense and Allowance for Doubtful Accounts, if there is no carryover balance from a prior period. If there is a carryover balance, that must be considered before recording Bad Debt Expense. The balance sheet aging of receivables method is more complicated than the other two methods, but it tends to produce more accurate results.

What Happens if You Don’t Report a Bad Debt Write-Off to the IRS?

The direct write-off method is a simple process, where you would record a journal entry to debit your bad debt account for the bad debt and credit your accounts receivable account for the same amount. If Ariel gets payment from the customer later, she can credit bad debt and debit accounts receivable to reverse the write-off journal entry. Ariel may then enter a debit to cash and a credit to accounts receivable to record the cash receipt. When you employ the allowance technique, you estimate how much bad debt you’ll have to account for over the course of the accounting period. However, it is based on a guess as to which outstanding bills will become bad debts in the long term.

When Should You Use the Direct Write-off Method?

The direct write off method is also known as the direct charge-off method. Below are some ways the direct write-off method and allowance method differ from one another. Let’s go through each one by one so you can decide for yourself if this method is right for your business.

GAAP says that all recorded revenue costs must be expensed in the same accounting period. As a result, although the IRS allows businesses to use the direct write off method for tax purposes, GAAP requires the allowance method for financial statements. As of January 1, 2018, GAAP requires a change in how health-care entities record bad debt expense. Before this change, these entities would record revenues for billed services, even if they did not expect to collect any payment from the patient.

If an account is more than six months old, the likelihood increases that you won’t collect the debt without a collection agency or lawsuit. If you are a business owner who requires regular insights about recording accounts, Akounto contributes to corporate citizenship by helping maintain accurate books of accounts. Expert support helps in responsible decision-making and safeguarding the stakeholders’ interests.