Bad debt expense:
A bad debt expense is a loss that the company incurs related to the accounts receivable. It is an invoice that is uncollectible since the customer is unable to pay or not willing to pay back the amount for some reason and all attempts of recovery have been made by the company.
The bad debt expense is supposed to be written off from the accounts receivable and charged as expenses into the income statement.
There are only two commonly used methods of writing-off the bad debt expense i.e.
- Allowance method
- Direct write-off method
In this article, we are going to talk about the advantages and disadvantages of the direct write-off method in the areas of accounting treatment as well as process management.
Direct write-off method:
This method requires an entity to recognize the bad debt expense once it occurs (which maybe after several years from the time of sale). The following entry is passed to record the bad debt expense for the year:
Here are the accounting entries for the direct write-off method:
Bad debt expense Dr
Accounts receivable Cr
The write-off amount is debited as the expenses in the period that it is approved to write off in the income statement. This write of does not affect the sales performance of an entity in the current period as well as the previous period.
It is affected only the bottom line of income in the current period. This is because expenses are recognized in this period. It is probably against the matching principle.
The write-off amount is also a credit to the accounts receivable account directly and it makes the account receivable amount become net amount.
It is important to know accounts receivable are the current assets in the balance sheet and the increase of them on debit while decreasing of them are on credit.
Advantages of direct write-off method:
- The direct write-off method requires minimum work since only one and the simple journal entry is required at the time of bad debt as compared to the allowance method which calls for reporting bad debt expense every year.
- The contra asset account complications are also avoided if the direct write-off method is used. No provisions or reporting of the provision is required which leads us to our second advantage mentioned below.
- There are remote chances of error considering no calculation of estimates for doubtful debt is required. The risks of overstating and understating expenses are also minimized.
- In the allowance method, the provision for doubtful debt requires significant judgment which could result in a material misstatement if an error is made.
- Since tax returns are prepared on a cash basis, this method of bad debt expense is the most appropriate and would save us any extra calculations or work for the preparation of income tax returns.
Disadvantages of direct write-off method:
- The major disadvantage of this method is that it fails to maintain the financial statements as per the generally accepted accounting principles (GAAP).
- It goes against the accrual system of accounting and violates the matching principle as well as the prudence concept.
- The matching principle states that expenses in an income statement shall relate to the revenue it has generated.
- In the case of the direct write-off method, we write off a bad debt expense when all means of recovering the money have expired. This happens after years from the time of sale.
- This means that the bad debt expense is expensed out in a later year instead of being expensed out as a provision for doubtful debt in the accounting period its related sales had occurred.
- A violation of accounting principles means that the financial statements are not portraying a true and fair view of the business.
- Similarly, the prudence concept states that an expense shall be recognized as soon as it is expected or is probable.
- In the direct write-off method, we write off accounts receivable after the bad debt has occurred instead of expensing out the doubtful debts every year that are expected at the time of sale.
- Another major problem is that the direct write-off method is an aggressive way of reporting bad debts since the profits are overstated in the early years since no provision is expensed out.
- As time passes, the bad debt amount becomes so huge that it ends up vastly understating the profit or net income of the company.