Accounts receivable of a company represent the amount that customers owe to the company in respect of the purchase of goods or services on credit.
Sales on credit mean that the revenue has been earned and recognized in the financial statements in the accounting period but the payment for it will be received at a later time as per agreement.
Accounts receivable are recording in the entity’s financial statements only if it is following the accrual basis accounting principle. If an entity uses a cash basis to prepare its financial statements, then receivables should recognize our so revenue.
Not all of the receivables are collectible. Some of the loyal customers make regular payments to the entity. Some of them pay late payments and some of those difficult customers do not make the payments.
In business worlds, these kinds of customers are normally put into blacklist and entities should not continue making the business with them.
However, in an accounting perspective, these uncollectible receivables are not allowed to be continuing records as current assets in the entity’s financial statements. They should write off those uncollectible receivables.
In this article, we will explain the accounting treatment and measurement of writing accounts receivable using the direct write-off method.
Bad debt expense:
When sales are made on credit, a lot of times customers fail to pay back the money they owe to the company due to various reasons.
This abnormal loss of the company is classified as an expense referred to as bad debt expense or uncollectible invoices.
There are two ways of dealing with the bad debt expense; the allowance method and the direct write-off method.
This method allows you to create a provision or reserve account for doubtful debts which are credited every year against accounts receivable. This method uses past data to predicts the uncollectible amounts of the current accounting periods.
And the prediction must do every year while the difference between the current year and the previous year are recognized in the income statement as expenses.
Let move to direct write-off method,
Direct write-off method:
The second method of writing-off accounts receivable is an easier way of reporting bad debt expenses. It directly writes off bad debts when they actually occur i.e. after several attempts of trying to recover the money.
This usually occurs in an accounting period following the one in which sales related to it were reported.
The entity is not required to predict the uncorrectable amount and then charged those uncollectable as expenses in the income statement when it is using the direct write-off method to records the bad debt of accounts receivables.
The following entry is passed to write off the debt:
Bad debt expense Dr
Accounts receivable Cr
The bad debt expense is recognized as an operating expense in the year in which it occurs in the income statement. It does not affect the total sales for those customers in the previous or current period.
However, it only affects the net income of the current accounting period since the expenses as the result of sales that might be in the previous period as charged in the current accounting period.
This also results in an understated profit for the year since this bad debt expense relates to sales made in a preceding year and the matching principle of accounting is being violated.
Simultaneously, the accounts receivable is credited and reduced correctly for the year but in the balance sheets of all preceding years, an overstated value of accounts receivable is reported since no provision is created and instead of reporting it at its net realizable value, the accounts receivable were reported at its original amount.
As mentioned above, there are no requirements for creating a provision or reporting a bad debt expense every year in this method. The direct write-off method is more appropriate for writing-off bad debts for the preparation of tax returns or if the cash basis of accounting is used.
Barbara sold goods to Babar for $5,000 on credit in 2016. Babar incurred a huge loss in his business in 2017 and his business has been deteriorating since. In 2019 Babar filed for bankruptcy.
His bank loans out-weighed his net assets and all the liquidation money was paid to the bank. How should Barbara report the $5,000 owed by Babar to her on her financial statements in 2019 using the direct write-off method?
Barbara should enter a journal entry in her books debiting the bad debt expense and crediting the accounts receivable as shown below:
Bad debt expense 5,000
Accounts Receivable 5,000
Simultaneously, Barbara’s income statement would report this bad debt expense under operating expenses hence reducing the net income as well as on her balance sheet reducing the accounts receivable balance by $5,000.
The problem with this method is the income statement is affected by an activity that may not be related to the period of its preparation.
If you look at statement of the example you will find that the revenue and profit of this transaction are recognized in the previous years while the loss arises will affect the current year’s income statement.