When a business extends credit to customers, some customers might be unable to pay on the spot. The direct write-off method is one way to account for these uncollectible receivables. With this method, a business writes off an account only when it determines that a customer cannot pay. This differs from the allowance method, which requires a business to estimate its uncollectible accounts each period. The direct write-off method is simpler to use, but its drawbacks might make it inappropriate for some small businesses.

Violates Matching Principle

When a business writes off an uncollectible account, it charges the amount as a bad debt expense on the income statement. With the direct write-off method, this expense might occur in a period after the initial sale was recorded, which violates the matching principle of generally accepted accounting principles, or GAAP. The matching principle requires a business to record revenues and their related expenses in the same accounting period. Because of this violation, GAAP allows a business to use the direct write-off method only for insignificant amounts.

Overstates Accounts Receivable

Accounts receivable is an asset on the balance sheet that represents the money customers owe. A business that uses the direct write-off method records the full amount of an account receivable at the time of a sale. But if some of these accounts become uncollectible, the reported accounts receivable balance would be too high. For example, if your small business uses the direct write-off method and reports $100,000 in accounts receivable, the balance can be misleading because you might collect less than the full $100,000.

Inaccurate Profits

Profit equals revenue minus expenses. Because a bad debt expense sometimes occurs in a later period than its related revenue, a company’s profits on its income statement might be inaccurate. Its profit would be too high when it records the revenue and too low when it records the related bad debt expense. For example, assume your small business records a $5,000 sale in the first quarter and writes that $5,000 off in the second quarter. Your first-quarter profit would be $5,000 too high and your second-quarter profit would be $5,000 too low.

Potential for Abuse

The direct write-off method allows more room for manipulation than other methods. Although a company is supposed to write off an account as soon as it determines the account to be uncollectible, it uses its judgment to decide when that moment arrives. This leeway allows an unethical company to inappropriately manage its profits. For instance, if a business wants to artificially raise its profits, it might overlook some past-due accounts until a later period so it can delay reporting the bad debt expense.

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