During a typical business transaction, a service is performed, or a product is sold, and the business is paid for that service or product at the time provided. However, it is all too common for a business to extend a customer’s time to pay, essentially providing a loan or line of credit to the customer. For financial accounting purposes, when the company is under the premise that an invoice is not going to be paid, it must find a way to write off the bad accounts or bad expenses. One popular method is the direct write-off method.
The direct write-off method, which uses the income statement approach, is a simple way with its single journal entry to eliminate doubtful debts that and past due accounts and will not be paid in the accounting period and are realized as uncollectible accounts expense. Under this accounting method, the amount owed is a debit from accounts receivable, and the company’s bad debt expense dr category is increased as a credit (cr) which eventually shows up on the income statement. This way of dealing with a bad debt expense account does not conform to the GAAP matching principle and is not considered the preferred method. However, it is a required method of reporting income to the Internal Revenue Service because it limits a company’s ability to inflate bad debts while decreasing taxable income.
The allowance method, which uses the balance sheet approach, is the more accepted method of dealing with bad debt because it conforms with the GAAP matching principle by providing an estimate of how much in unpaid accounts will be at the end of the year. This estimate is based on the sales and collections information from previous years and is reported by setting up a holding account called the allowance for doubtful accounts x. This accounting principle allows for the client’s balance to remain while reducing the accounts receivable on the balance sheet by creating a contra-asset account.
Bad debt is entered as an adjusting entry on the financial statements for the company and flows to the balance sheet. Accounts receivable can be negative if more credit is issued to clients than actual revenue collected.
Considering the allowance method, which is the accrual basis of accounting, is the preferred practice of managing unpaid debts, there are still many reasons for a company to choose the direct write-off method. The most obvious reason is easier accounting and less work to deal with bad debt. The other popular motivation for this accounting method is reporting to the IRS. For federal income tax purposes, the direct write-off method can be used under both cash and accrual accounting methods and allows for the reduction of reportable taxable income to the IRS without going through the hassle of a complex adjustment at the end of each year.
Bad debt can be written off of annual tax returns as actual losses. Always refer to a consultant such as a CPA if in doubt.