Under the direct write off method, a company does not anticipate bad debt expense. Rather, it waits until an account is actually written off as uncollectible before recording bad debt expense. This means its accounts receivable will be reported on the balance sheet at their full amounts—implying that all of the accounts receivable will be turning to cash. If there is some doubt concerning the collectibility of some of the receivables, the assets are potentially overstated and the company’s profit is potentially overstated. Since there is usually a significant amount of time between a credit sale and the write off of a bad account, the bad debt expense will occur in a much later period than the revenue from the sale. This is a problem under the matching principle.

The accounting profession prefers the allowance method over the direct write off method because the accounts receivable will be presented on the balance sheet with a reduction called the allowance for doubtful accounts. This means the net amount of the accounts receivable will be lower and closer to the amount that will actually be collected. Bad debt expense is reported at the time that the allowance for doubtful accounts is created and adjusted. Hence, the bad debt expense is reported closer to the time of the credit sale.

It should be noted that the Internal Revenue Service requires the direct write off method. They prefer to see the tax deduction for bad debt expense only when an account receivable is actually written off—as opposed to allowing a deduction for an anticipated potential loss.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years. He is the creator and author of all the content found on AccountingCoach.com. You can read 1,500 testimonials praising his ability to explain accounting in a way that anybody can understand.

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