Direct Write Off MethodDefined with Examples

Written By:
Lisa Borga

What is the Direct Write Off Method?

The direct write off method, which is also known as the direct charge-off method, is a method businesses use clear their bad debts to expenses after an individual invoice has been found to be uncollectible.

For a business using accounting software, this is done by generating a credit memo for each customer with an uncollectible debt.

Doing this will offset the amount of debt found to be uncollectible.

Generating a credit memo for the uncollectible debt will cause the bad debt expense account to be debited and the accounts receivable account to be credited.

However, there will not be a reduction in recorded sales when using this method, it will only create an increase in bad debt expense.

Example of the Direct Write Off Method

An example of this would be an auto parts business that has a credit sale of $5,000.

The business would record this sale by debiting their accounts receivable account and crediting their sales account.

If the business found after waiting for two months that the customer could only pay $2,000, the business would need to write off $3,000.

The business would do this by recording a credit of $3000 to its accounts receivable account and recording a debit of $3000 to the account for bad debt expense.

After this is done, the revenue account has not been changed.

The receivable amount the customer was unable to pay has been eliminated, and there is now an expense for that amount in the bad debt account.

Limitations of the Direct Write Off Method

The direct write off method does not follow the matching principle.

This principle requires that expenses be matched with the revenues they are associated with for a period.

When businesses follow the matching principle, it helps give investors a clear idea of the revenue a business has generated.

If a business uses the direct write off method, it will delay recognizing expenses that are related to the transaction generating the revenue.

This method can make a business seem to be more profitable than it really is by delaying the expenses associated with some transactions.

An example of this would be a business that has sales of $2 million and recognizes these in one accounting period.

It could be months before a company collects all the receivables from the sales and then uses the direct write off method to charge any uncollectible debts to expense.

This method could cause the business to appear more profitable in the month in which the sales are made due to any expected bad debts not being accounted for, and then less profitable in the month when the bad debts are charged to expense.

Thus, when a business uses the direct write off method, investors looking at the business’s financial statements may not get an accurate idea of the business’s revenue during this time.

Although, for immaterial amounts, the direct write off method may have little effect on the business’s financial reports or an investor’s view of the business.

Direct Write Off Method Alternative

There is an alternative to the direct write off method.

To use the alternative method, you’ll need to set up an account typically called the allowance for doubtful accounts or sometimes the allowance for bad debts, which is a contra asset account for the accounts receivable account that will reduce accounts receivable to the amount your business expects to receive.

This account will be used to record an estimate of bad debt expenses.

When your business files taxes, it must use the direct write off method.

The IRS requires the direct write off method because it believes otherwise businesses would use the allowance method and estimate a large amount of bad debt to lower their taxes.