Pledging, Selling, Direct Write-Off Method

Sometimes the factor will purchase the accounts receivables with recourse. This means the company that sold the receivables remains financially responsible if a customer does not remit the full amount to the factor. When the factor purchases the receivables without recourse, the company selling the receivables is not responsible for unpaid amounts.

After two months, the customer is only able to pay $8,000 of the open balance, so the seller must write off $2,000. It does so with a $2,000 credit to the accounts receivable account and an offsetting debit to the bad debt expense account. Thus, the revenue amount remains the same, the remaining receivable is eliminated, and an expense is created in the amount of the bad debt. Net realizable value is the amount the company expects to collect from accounts receivable.

Direct Write-Off and Allowance Methods

As the accountant for a large publicly traded food company, you are considering whether or not you need to change your bad debt estimation method. You currently direct write-off method use the income statement method to estimate bad debt at 4.5% of credit sales. You are considering switching to the balance sheet aging of receivables method.

A company that ends the year with bad debt can write that bad debt off on their tax return. In fact, The IRS requires businesses with bad debt to use the direct write-off method for their return, even though it does not comply with Generally Accepted Accounting Principles (GAAP). The direct write-off method lets you charge bad debts directly to an expense such as the Allowance for Bad Debt account used in the journal entries above. By far the easiest write-off method, the direct write-off method should only be used for occasional bad debt write-offs. One method, the direct write-off method, should only be used occasionally, while the allowance method requires you estimate bad debt you expect before it even occurs. No matter how carefully and thoroughly you screen your customers or manage your accounts receivable, you will end up with bad debt.

How To Use the Direct Write-Off Method

You’ll need to decide how you want to record this uncollectible money in your bookkeeping practices. The estimated amount is debited from the Bad Debts Expense and credited to an Allowance for Doubtful Accounts to maintain balance. Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own.

An unpaid invoice is a credit in the accounts receivable account, as opposed to the customary approach. This is because accounts receivable is an asset that grows in value when debited. The specific action used to write off an account receivable under this method with accounting software is to create a credit memo for the customer in question, which offsets the amount of the bad debt. Creating the credit memo creates a debit to a bad debt expense account and a credit to the accounts receivable account.

It writes off the true balance, not an estimate

Every time a business extends payment terms to a customer, that business is taking on risk. When a customer defaults on an amount due, this is called bad debt. Let’s consider a situation where BWW had a $20,000 debit balance from the previous period. The following table reflects how the relationship would be reflected in the current (short-term) section of the company’s Balance Sheet. The first entry reverses the bad debt write-off by increasing Accounts Receivable (debit) and decreasing Bad Debt Expense (credit) for the amount recovered. The second entry records the payment in full with Cash increasing (debit) and Accounts Receivable decreasing (credit) for the amount received of $15,000.