Direct write-off method:
Direct write-off method is one of the two commonly known methods of treating the bad debt expense.
Through the direct write-off method, we straightforwardly book a bad debt expense by debiting the bad debt expense account and crediting the accounts receivable account.
Hence, the sales amount remains intact, account receivables are eliminated and the bad debt expense account increases.
For example, Ali made sales worth $2000 in 2018. The bad debt occurred in 2019 when the customer ran off without payment of the debt. What will be the treatment as per the direct write-off method?
A bad debt expense of $2,000 will be reported as operating expense in the income statement of Ali for the year ended 2019 and the accounts receivable balance would be reduced by $2,000. The following entry would be passed:
Bad debt expense DR $2000
Accounts receivable CR $2000
Allowance method is the second method of treating the bad debts expense and involves creating a provision or contra account.
An estimate is calculated as a percentage of accounts receivable or net sales or is based on the time period the invoices haven’t been paid for.
This estimate is the amount of expected uncollectible invoices and is reported as bad debt expense for the year.
It also reduces accounts receivable accordingly so that it is reported at its net realizable value.
The direct write-off methods violate the matching principle of accounting which states that every expense booked for the year should match the revenue it has generated.
In the direct write-off method, bad debts are expensed out when they occur and are not related to the sales for the year.
On the contrary, the allowance method allows you to book a provision for the doubtful debt at the end of each year.
Hence, the bad debt expense recorded each year is matched to the net sales for the year as per the matching principle of accounting.
The direct write-off method is an easier way of treating the bad debt expense since it only involves a single entry where bad debt expense is debited and accounts receivable is credited.
The allowance method is more complicated since it requires you to create a provision account which is a contra-asset account.
This procedure might result in wrong accounting entries negatively affecting the true and fair view of the financial statements of the company.
As per the prudence concept of accounting which is also referred to as the conservatism principle, revenue shall only be recognized when certain and expense shall be booked when probable.
In the direct method of accounting, bad debt expense is booked when all attempts of recovery have been exhausted and there is no chance of receiving the money.
The accounts receivable is reduced by the bad debt expense and sales remain intact.
Conversely, provision for doubtful debt is booked as a bad debt expense under the allowance method. A provision is a probable outflow of cash of an uncertain amount or time.
This provision reduces the accounts receivable on the balance sheet since it is a contra asset. The allowance method shows a true and fair view of the financial statements since it follows the generally accepted accounting principles (GAAP).
Chances of error:
The allowance method involves calculation of an estimate which is based on significant judgment. If this estimate is miscalculated, it may lead to material errors distorting the true and financial view of financial statements.
This problem, however, does not occur in the direct write-off method since no calculation is involved and the bad debt is of a particular invoice.