Lesson Objectives:- What the direct write-off method is
- Comparing the allowance method versus the direct write-off method
- Flaws of the direct write-off method
The direct write-off method differs significantly from the allowance method as we are not using an allowance for the amount of bad debt. This also means that we will not be making estimates, instead the company will directly write off the receivable when it occurs.
For example, if a company finds out that $5,000 worth of receivables will not be collected, they will need to record a journal entry to write off the bad debt expense. The bad debt expense of $5,000 would be debited and accounts receivable would be credited for $5,000.
Let's take a look at the negative aspects of using the direct write-off approach by comparing it to the allowance method.
With the allowance method, if the revenues for 2013 were $5,000 and the bad debt expense was estimated to be $2,000, the expense would be matched to the revenues in the same accounting period.
If the direct write-off approach was used instead, there would not be an expense entry in 2013. If two years were to pass by and the company determined they were not going to collect $2,000, the amount would then be written off in 2015. This is a direct violation of the matching principle as the expense is not matched to the revenue in the same accounting period.
This exemplifies why the allowance method is used under the IFRS and ASPE standards to calculate the bad debt expense adjustment. The direct write-off method is not allowed under the IFRS standards because of the fact it doesn't follow the matching principles.
Without using an allowance for doubtful accounts, the receivables will not have an accurate value for the amount in the receivables account.
If the receivables start at $8,000 and the AFDA allowance is estimated at $4,000, the net receivables would be calculated at $4,000.
With the direct write-off approach, there is no allowance for bad debts which means that the net receivables will be significantly overstated for that accounting period. When the receivable is finally deducted in 2015, the net realizable value would then be decreased to 4,000.
Take a look at the comparison above of how the AFDA estimate adjusts the net realizable value to an accurate value with the allowance method, while the direct write-off method wouldn't record the drop in the receivables value until years later.
While the NRV value would be consistent for the allowance method, it would take years for the direct write-off method to reflect the appropriate amount.
In summary, the direct write-off method doesn't fall in line with the matching principle and also doesn't yield a consistent net realizable value for receivables.
This lesson concludes our review of receivables and bad debts. In the next lesson, we will start talking about revenue and how it is recognized in the accounting world.