Difference Between Direct Write Off Method and Allowance Method

If a customer defaults the payment, this will be called a ‘bad debt’. When an account is deemed to be uncollectible, the company must remove the receivable from the accounts and record an expense. This is considered an expense because bad debt is a cost to the business. Direct write off method and allowance method are the two widely used methods to account for bad debts. The key difference between direct write off method and allowance method is that while direct write off method records the accounting entry when bad debts materialize, allowance method sets aside an allowance for possible bad debts, which is a portion of credit sales made during the year.  When goods are sold on credit, the customers settle due amounts at a later date.

CONTENTS
1. Overview and Key Difference
2. What is Direct Write Off Method
3. What is Allowance Method
4. Side by Side Comparison – Direct Write Off Method vs Allowance Method
5. Summary

What is Direct Write off Method?

The direct write off method allows a business to record bad debt expense only when the company is confident that the debt is unrecoverable. The account is removed from the accounts receivable balance and bad debt expense is increased.

E.g. On 11.30.2016, ABD Company sold goods worth of $1,500 to Customer G with a credit period of 3 months. By the last week of February 2017, Customer G was declared bankrupt and was unable to pay. ABD should record the bad debt as follows.

Bad debts                            DR $1,500

Accounts receivable            CR $1,500

This a simple and the most convenient method of recording bad debts; however, it has a major drawback. This violates the matching principle (expenses should be recorded for the period where the revenue is incurred) of accounting because it recognizes bad debt expense which may be related to the previous accounting period. This is evident from the above example where the credit sale takes place in 2016, and the bad debt is discovered in 2017.

What is Allowance Method?

Under this method, an allowance for possible bad debts is created for the same accounting period in which the credit sales are made. Therefore, this method is compatible with matching principle. Since the actual amount of bad debts that will materialize from this allowance is unknown, it is also referred to as ‘allowance for doubtful debts’. The percentage that should be estimated as bad debts will be decided on past experience of nonpayment by customers.

E.g. XYZ Company has $50,000 outstanding from customers at the end of the financial year, 12.31.2016. Depending on past experience, it is estimated that 8% ($4,000) will be bad debts. Thus, the allowance will be recorded as,

Bad debts                                             DR $4,000

Allowance for doubtful debts               CR $4,000

While some level of bad debts is inevitable, businesses should always attempt to maintain it at a minimum level since accounts receivable is usually considered as a very important current asset as far as liquidity is concerned. Some companies even get the assistance of debt collection agencies to collect due amounts from customers. Accounts receivable aged analysis is an important report prepared in this regard that shows the amounts outstanding from each customer and for how long they have been outstanding. This will indicate any breaches of credit terms if there are any.

What is the difference between Direct Write Off Method and Allowance Method?

Summary – Direct Write Off Method vs Allowance Method

While both are methods of accounting for bad debts, the difference between direct write off method and allowance method can be seen according to the way they are treated in accounting records. If Generally Accepted Accounting Principal (GAAP) are used, allowance method is applicable since it is compatible with the matching concept. Prior to granting credit sales, credit worthiness of customers should be sufficiently evaluated in order to reduce the negative effects of bad debts.

Reference:
1. “Direct Write-off and Allowance Methods for Dealing with Bad Debt.” Accounting In Focus. N.p., n.d. Web. 20 Mar. 2017.
2. Jan, Irfanullah. “Bad Debts Direct Write-off Method.” Journal Entry | Receivables. N.p., n.d. Web. 20 Mar. 2017.
3. Jan, Irfanullah. “Bad Debts.” . Journal Entries  Example. N.p., n.d. Web. 20 Mar. 2017.
4. “GAAP Rules for Writing Off Accounts Receivable.” Chron.com.  15 Dec. 2011. Web. 21 Mar. 2017.

Image Courtesy:
1. “Debt Collection” (CC BY-SA 3.0 NY) via Creative Commons Images