The Direct Write-Off Method for Accounts Receivable
When businesses extend credit to customers, they expect the customer to pay the bill in full. Sometimes customers default, or fail to pay their bill. Some customers run into financial challenges and file for bankruptcy. Other customers simply choose not to pay. The company needs to recognize those accounts that the customers will not pay. Some companies choose to use the direct write-off method to recognize these accounts receivables that the company will not collect.
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How To Write Off
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When the company realizes the sale, it records the transaction in the financial records. The company increases Sales Revenue and increases Accounts Receivable for the amount of the sale. When the company recognizes that the customer will default on the money owed, it records the default in the financial records. It increases Uncollectible Account Expense and decreases Accounts Receivable for the remaining balance on the account.
When to Write Off
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A company that uses the direct write-off method maintains a balance in the Accounts Receivable account for each customer account until it receives a notice that the customer will default. This notice includes a letter of bankruptcy or written communication from the customer regarding financial difficulties. The company makes no entry until it knows that the customer will not pay the account.
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Why Use This Method
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Companies use this account for a couple reasons. This method requires less work from the accountant. She only makes an entry when she knows the company will default on the account. Also, this method relies on actual source documents to determine which accounts to write off. These source documents detail which account will default and the amount of money that will not be received. Alternative methods require the accountant to estimate the total accounts that will default at the time of sale.
Limitations of This Method
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This method incurs some limitations in financial reporting. Company revenues appear overstated on the financial statements. This occurs because some of the original accounts will default, preventing the company from receiving payment. This also prevents the company's ability to match the expected revenues with the expense of earning that revenue, which is required by generally accepted accounting principles.
Alternative Method
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Most companies use the allowance method to report uncollectible accounts. This method requires the company to maintain an allowance account. The company estimates the total amount of customer accounts that will default by reviewing historical data. The accountant records this amount in an account called Allowance for Doubtful Accounts, which is a contra asset account. This account reduces the total value of Accounts Receivable. The accountant also records this amount in Uncollectible Accounts Expense, which reduces the total revenues at the time of sale. This method follows generally accepted accounting principles.
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