Direct Write-Off Vs Allowance Method – Meaning, Differences & Similarities

Introduction

When a company provides a service to a customer on credit, there is an inherent risk that the customer might not pay on time or might not pay at all for services offered. This unpaid amount is commonly referred to as bad debt. So how do businesses account for these bad debts?

Businesses need to appropriately recognize and record bad debts as expenses in order to balance books, which in turn ensures accurate financial reporting. They can either use the direct write-off method or the allowance method for bad debt recordkeeping.

In this blog, we are going to explore the direct write-off vs. allowance methods and understand how they differ from each other.

What is the Direct Write-Off Method?

The direct write-off method is an accounting method to record uncollectible accounts receivables. As per this method, a bad debt expense is recognized and written off when an invoice is found to be uncollectible. This means that a company will record bad debt as an expense once they deem it to be uncollectible.

The direct write-off method does not run on the assumption that a certain invoice could remain unpaid, and therefore, it does not adhere to the Generally Accepted Accounting Principle (GAAP)’s matching principle. According to the GAAP standards, expenses and revenues need to be recorded in the same accounting period. However, with the direct write-off method, the bad debt expense is not matched with the revenue it helps generate. Due to this, public companies that need to adhere to GAAP accounting standards cannot use the direct write-off method to account for uncollected invoices.

Example of the Direct Write-Off Method

Let’s consider an example to understand how a business uses the direct write-off method to account for bad debts. 

Suppose a company ABC provides services to a client for $1000. The client initially promised to pay after three months but didn’t do so. ABC will try to contact the client and send constant reminders about the unpaid invoice. However, ABC notices that the client hasn’t paid the invoice even after six months. At this point, ABC will deem this particular account receivable uncollectible. 

To write off this particular bad debt, ABC will record the following journal entry:

What is the Allowance Method?

According to the allowance method, a company estimates that a certain portion of their outstanding accounts receivable will not be collected. This means that at the end of each accounting period, the company will create an account named ‘allowance for doubtful accounts’ and allocate the estimated uncollectible receivables amount to this account.

Unlike the direct-write off method, the allowance method follows the GAAP standards and is therefore the accepted method of accounting to write off bad debts. Businesses using the allowance method need to estimate the percentage of uncollected accounts receivable at the end of each accounting period. While it’s difficult to predict the accurate amount, they can predict an amount based on past customer behavior.

Example of the Allowance Method?

Now, let’s understand the allowance method better with the help of an example. 

Considering our previous scenario, where the ABC company doesn’t receive the bill of $1000 from the client despite their best efforts to collect the amount. 

Before ABC even writes off the bad debt, they would have created an ‘allowance for doubtful accounts’ account by predicting the accounts receivable they deem uncollectible. Suppose ABC predicts that out of $100,000 total accounts receivable, $20,000 is uncollectible. 

They will record the following journal entry for the same:

Now, coming back to the unpaid $1000 invoice. Once ABC discovers that the client is not going to pay, they will use the balance in the allowance for doubtful accounts to write off the bad debt. 

The journal entry would be the following:

After this, the balance in allowance for doubtful accounts will reduce to $19,000.

Direct Write-Off Method Vs. Allowance Method

Differences between allowance and direct write-off method 

Both the direct write-off method and the allowance method for writing off bad debts contrast starkly based on a lot of factors. Here are the major differences between the two: 

Similarities between allowance and direct write-off methods 

Despite being contrasting in nature, direct write-off and allowance methods serve the same purpose. Here are some of the similarities between the two accounting practices to write off bad debt:

• Both methods are used to account for bad debts in the books and ensure that the net income of the company is reported accurately. 
• Both methods eventually impact the income statement by recognizing bad debt expense, which reduces the net realizable income of the company. 
• Both methods impact the balance sheet by reducing the net realizable value of accounts receivable.

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FAQs

Q1. Why is the allowance method preferable to the direct write-off method?

While both allowance and direct write-off methods are used to write off bad debt in the accounting books of a company, the former is considered to be more accurate. This is because the allowance method follows the matching principle and complies with accounting standards such as GAAP. 

Q2. What is the difference between direct method and allowance method of accounting for bad debts?

The direct method recognizes bad debt only when it is identified as uncollectible. The allowance method, on the other hand, estimates bad debt expense at the end of each accounting period and uses allowance for doubtful accounts to write it off. The allowance method follows the matching principle, but the direct method does not. 

Q3. What are the advantages of the direct write-off method?

The direct write-off method is a simple method where businesses can write off the exact bad debt amount that goes uncollected. They don’t need to estimate the bad debt expense beforehand. The journal entries for this method are further straight-forward and don’t require the complications of a contra-asset account. 

Q4. Why isn’t the direct write-off method accepted under GAAP?

The direct write-off method of accounting for bad debt isn’t accepted under the GAAP guidelines as it does not follow the matching principle. The bad debt is recorded in the books once it is deemed uncollectible; however, this means that the expense is not recorded in the same period as the revenue is generated. 

Q5. Why is the allowance method required by GAAP?

The allowance method uses a contra-asset account to write off the bad debt expense. The allowance for doubtful accounts is set at the end of each year and is used to write off any bad debt expense that occurs during the accounting period. This method follows the matching principle and is therefore accepted under GAAP.