Question

How do the allowance method and the direct write-off method of handling credit losses differ with respect to the timing of bad debts expense recognition?

Answer 1

The primary differences between the direct write-off and the allowance method for accounting for bad debts are the timing of when bad debts are reported on the books and their ultimate impact on the income statement and balance sheet.

The first difference between the direct write-off method and the allowance method of accounting for bad debt expense is the timing of when bad debt expense is recorded. The impact on the income statement differs under the methods. Bad debts are recorded when estimated under the allowance method, thereby matching revenues and expenses. No such estimates are made under the direct write-off method. Rather, bad debts are only recorded when an actual write-off occurs, which might cause revenues and related expenses to be recorded in different periods. The direct write-off method has the effect of understating expense and overstating net income in a particular reporting period when an account is determined to be uncollectible in a period subsequent to the period in which the related sales or revenue was reported. As a result of this failure to match revenue with expenses, the direct write-off method is not permitted for use for financial reporting purposes unless bad debts are insignificant to a company.

The second difference between the direct write-off method and the allowance method of accounting for bad debt expense is the use of estimates. The allowance method uses the allowance for doubtful accounts to capture accumulated estimates of bad debts. This method appropriately reduces the accounts receivable balance to its net realizable value, or the amount a company can expect to collect from those receivables in the future. When bad debt estimates are recorded, the allowance for doubtful accounts is increased. Because it is a contra asset account, this increase has a decreasing effect on the receivables account to which the allowance for doubtful accounts is related. As a result, the allowance method provides a relevant presentation of the balance sheet at all times. The direct write-off method does not report bad debt estimates; therefore, it does not use the allowance for doubtful accounts when reporting bad debts. As a result there is no reporting of net realizable value under the direct write-off method, which reduces the relevancy of the balance sheet.

The direct write-off method recognizes bad accounts as an expense at the point when judged to be uncollectible and is the required method for federal income tax purposes. The allowance method provides in advance for uncollectible accounts think of as setting aside money in a reserve account.