Discuss the reasons why the allowance method is preferable to direct write-off method

The Direct Write-off method is a process of booking the unrecoverable part of receivables that are no longer collectible by removing that part from the books of accounts without prior booking for the provisions of bad-debts expenses. In other words, it can be said that whenever a receivable is considered to be unrecoverable, this method fully allows them to book those receivables as an expense without using an allowance account.

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Source: Direct write-off method (wallstreetmojo.com)

Bad Debts Expenses for the amount determined will not be paid directly charged to the profit and loss account under this method. The direct write-off method is used only when it is inevitable that a customer will not pay. There is no recording of the estimates or use of allowance for the doubtful accounts under the write-offWrite-offWrite off is the reduction in the value of the assets that were present in the books of accounts of the company on a particular period of time and are recorded as the accounting expense against the payment not received or the losses on the assets.read more methods.

The following entry should be passed:-

The write off amount is debited as the expense in the period approved to write off in the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more. It does not affect the sales performance of the entity in the current period and the previous period. It affects only the bottom lineBottom LineThe bottom line refers to the net earnings or profit a company generates from its business operations in a particular accounting period that appears at the end of the income statement. A company adopts strategies to reduce costs or raise income to improve its bottom line. read more of income in the current period. It is because the expenses are recognized in this period. It is probably against the matching principlesMatching PrinciplesThe Matching Principle of Accounting provides accounting guidance, stating that all expenses should be recognized in the income statement of the period in which the revenue related to that expense is earned. This means that, regardless of when the actual transaction is made, the expenses that are entered into the debit side of the accounts should have a corresponding credit entry in the same period.read more.

Table of contents

• What is the Direct write-off method?
  • Examples of Direct Write-Off Method
    • Example #1
    • Example #2
  • Advantages
  • Disadvantages
  • Reasons Why Direct Write-off Method is not preferred in the Accounting Profession?
  • Conclusion
  • Recommended Articles

Examples of Direct Write-Off Method

Example #1

Assume Natalie owns a shop of confectionery. Natalie has many customers who purchase goods from her on credit and pay. One of her customers purchased products worth $ 1,500 a year ago, and Natalie still hasn’t been able to collect the payment. After trying to contact the customer a number of times, Natalie finally decides that she will never be able to recover this $ 1,500 and decides to write off the balance from such a customer. Using the direct write-off method, Natalie would debit the bad debts expenses account by $ 1,500 and credit the accounts receivable account with the same amount.

Example #2

An accounting firm prepares a company’s financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more as per the laws in force and hands over the Financial Statements to its directors in return for a Remuneration of $ 5,000. The remuneration has been outstanding for a year now. The firm is taking regular follow-ups with the Company’s directors, to which the directors are not responding. The firm then debits the Bad Debts Expenses for $ 5,000 and credits the Accounts Receivables for $ 5,000. The firm partners decide to write off these receivables of $ 5,000 as Bad Debts are not recoverable.

Advantages

• The main advantage of the Direct Write-off method is that it is straightforward to book and record in books of accounts. Companies only have to pass two journal entries for the amount of the customer’s bad debt.
•  The other advantage is that the company can write off its bad debts on its annual tax returns.
• The contra asset accountContra Asset AccountA contra asset account is an asset account with a credit balance related to one of the assets with a debit balance. When we add the balances of these two assets, we will get the net book value or carrying value of the assets having a debit balance.read more compilations are also avoided if this method is used.
• There are remote chances of error, considering no calculation of estimates of doubtful debts is required. The risk of overstating and understating expenses in the income statements is also minimized.
• Since tax returns are prepared on a cash basisCash BasisCash Basis Accounting is an accounting method in which all the company's revenues are accounted for only when there is an actual cash receipt, and all the expenses are recognized when they are paid. Small companies and individuals generally follow this accounting method.read more, this method of bad debt expenses is the most appropriate and would save us any extra calculations or work to prepare income tax returns.

Disadvantages

• The major disadvantage of the Direct Write-off method is the possibility of expense manipulation because companies record expenses and revenue in different periods.
• Another disadvantage of direct write-off is that the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more is not accurately representing the company’s accounts receivables.
• One major disadvantage is that it fails to maintain the financial statements according to the generally accepted accounting principle (GAAPGAAPGAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting.read more).
• A violation of accounting principles means that the financial statements are not portraying an accurate and fair view of the business.
• It goes against the accrual system of accounting and violates the matching principle and the prudence conceptPrudence ConceptPrudence Concept or Conservatism principle is a key accounting principle that makes sure that assets and income are not overstated and provision is made for all known expenses and losses whether the amount is known for certain or just an estimation i.e. expenses and liabilities are not understated in the books of accounting.read more.

Reasons Why Direct Write-off Method is not preferred in the Accounting Profession?

• The accounts receivable at the end of the financial year would be most likely to be reported in the balance sheet at an amount greater than the amount received from those receivables.
• The matching principle isn’t followed as the losses from this account are recognized as bad debts or several uncollectible periods after the income was earned
• The bad debts expenses resulting from the operating activities on credits will appear on the income statement or profit & loss account only after identifying these bad debts and altering them from the company’s accounts receivables.
• The contra asset account compilations are avoided if the direct write-off method is used. No provisions or reporting of provisions are required in this method.

Conclusion

The direct write-off method is the simplest method to book and record the loss on account of uncollectible receivables, but it is not according to the accounting principles. It also ensures that the loss booked is based on actual figures and not on appropriation. But it violates the accounting principlesAccounting PrinciplesAccounting principles are the set guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while recording and presenting the financial information in the books of accounts.read more, GAAP, matching concepts, and a true and fair view of the Financial Statements.

Seeing and considering all these points, it is concluded that only being a simple method to record the transaction is not the requirement of an accounting transactionAccounting TransactionAccounting Transactions are business activities which have a direct monetary effect on the finances of a Company. For example, Apple representing nearly $200 billion in cash & cash equivalents in its balance sheet is an accounting transaction. read more.  It must be within the rules and laws framed by the bodies for an accounting of transactions so that a true and correct picture of the Financial Statements can be shown to the stakeholder of the entity. Therefore it is not advised to use the Direct Write-off Method to book for the uncollectible receivables. Instead, the company should look for other methods such as appropriation and allowance for booking bad debts for its receivables.

Recommended Articles

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