Lesson 46: Direct Write-Off Method
In this lesson, we will learn what the direct write-off method is, compare the
allowance method versus the direct write-off method, and discuss the 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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.