Accounting For Uncollectible Receivables

Acknowledging and preparing for possible losses from uncollectible accounts contributes to a more realistic depiction of the company’s financial situation, fostering transparency and informed financial management. In exchange for $ 5,000, an accounting firm compiles a company’s financial accounts in accordance with applicable legislation and delivers them over to the company’s directors. The firm is following up with the Company’s directors on a regular basis, but they are not responding. The company then debits $ 5,000 from Bad Debts Expenses and credits $ 5,000 from Accounts Receivables. The firm’s partners decide to write off these $ 5,000 receivables as non-recoverable Bad Debts. As a direct write-off method example, imagine that a business submits an invoice for $500 to a client, but months have gone by and the client still hasn’t paid.

Writing-Down Allowance (WDA) Made Simple for Beginners

• This method adheres to the matching principle, ensuring that bad debt expenses are recognized in the same period as the related sales.
• 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.
• You credit the Accounts Receivables account with the remaining $2,500 you should have received, and debit the Bad Debt Expense account with the same.
• While it’s difficult to predict the accurate amount, they can predict an amount based on past customer behavior.

Because the risk to the business is relative to the number of accounts and the amount of cash tied up in receivables, larger companies cannot take a “wait and see” approach to capturing potential bad debts. 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. The direct write-off method is an accounting method to record uncollectible accounts receivables.

Understanding Bad Debt

The direct write-off method is used only when we decide a customer will not pay. We do not record any estimates or use accounting the Allowance for Doubtful Accounts under the direct write-off method. This method violates the GAAP matching principle of revenues and expenses recorded in the same period. 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-off methods.

#2. Inaccuracy in the balance sheet

Allowance for Doubtful Accounts decreases (debit) and Accounts Receivable for the specific customer also decreases (credit). Allowance for doubtful accounts decreases because the bad debt amount is no longer unclear. Accounts receivable decreases because there is an assumption that no debt will be collected on the identified customer’s account. As you’ve learned above, the delayed recognition of bad debt violates GAAP, specifically the matching principle. Therefore, the direct write-off method is not used for publicly listed companies; the allowance method is used instead.

On the other hand, businesses lacking such capabilities may find the direct write-off method more practical, despite its potential drawbacks in financial reporting accuracy. To illustrate, let’s continue to use Billie’s Watercraft Warehouse (BWW) as the example. Thus it is important to note that the percentage of receivables approach considers any existing balance in the allowance when calculating the amount of bad debt expense. To illustrate, let’s assume that Kenco has a receivables balance of $25000 at the end of the financial year. Based on past experience, the business expects that 1% of its receivables balance will be uncollectible.

Reasons Why it is not preferred in the Accounting Profession?

However, with this method, poor expenses may not be recognized as such until the next period. For example, if you made a sale at the conclusion of one accounting month that ended in December, you may not recognize the bad debts until the beginning of March. A direct write-off frequently occurs in a different year than when the sale was made, or when direct write-off method the revenue was recorded by your company.

Revenue Reconciliation

The bad debts expense account is debited for the actual amount of the bad debt. This directly impacts both the revenue as well as the outstanding balance due to the company. It causes an inaccuracy in the revenue and outstanding dues for both the accounting period of the original invoice as well as the accounting period of it being classified as a bad debt. Since the allowance method uses an estimated amount, it is not as accurate as of the direct write off method. In the direct write off method, the bad debts expense account is debited and the accounts receivable is credited.

• In this example, the $85,200 total is the net realizable value, or the amount of accounts anticipated to be collected.
• Whenever you have sufficient information to draw the conclusion that a specific customer is unlikely to make payment, that is when you’ll reduce the AR balance.
• Consider why the direct write-off method is not to be used in those cases where bad debts are material; what is “wrong” with the method?
• This is because although the direct write-off method doesn’t follow the Generally Accepted Accounting Principles (GAAP), the IRS requires companies to use this method for their tax returns.

If you infrequently receive https://www.bookstime.com/articles/conversion-costs uncollected payments, then the direct write-off method can help your organization easily handle bad debt. In this post, you’ll learn how to use the direct write-off method in the journal entry for your business, as well as the potential benefits and drawbacks of the direct write-off. GAAP requires these larger companies to follow the Matching Principle–matching expenses (or potential expenses) to the same accounting period where the revenue is earned.