The direct method has the precision and accuracy of the actual amount going to bad debts. The outstanding balance of $2,000 that Craft did not repay will remain as bad debt. When a specific customer has been identified as an uncollectible account, the following journal entry would occur. The direct write-off method does not comply with the generally accepted accounting Cash Flow Management for Small Businesses principles (GAAP), according to the Houston Chronicle. Since an increase in this account causes its paired asset (i.e. accounts receivable) to decline, the account is considered to be a contra-asset, i.e. the allowance for doubtful accounts is net against A/R to reduce its value. But under the context of bad debt, the customer did NOT hold up its end of the bargain in the transaction, so the receivable must be written off to reflect that the company no longer expects to receive the cash.

• Then, in the next accounting period, a lot of their customers could default on their payments (not pay them), thus making the company experience a decline in its net income.
• The reliability of the estimated bad debt – under either approach – is contingent on management’s understanding of their company’s historical data and customers.
• This entry reduces the accounts receivable and recognizes the bad debt expense in the income statement.
• The aging method breaks down receivables based on the length of time each has been outstanding and applies a higher percentage to older debts.
• Another category might be 31–60 days past due and is assigned an uncollectible percentage of 15%.
• The allowance method must be used when producing financial statements.
• Implementing the allowance method can enhance the accuracy of financial reporting by smoothing out income fluctuations.

Impact on Financial Statements

The Allowance Method complies with Generally Accepted Accounting Principles (GAAP), which require that expenses be matched with the revenues they help generate. This method ensures that financial statements are consistent, comparable, and provide a fair representation of the company’s financial position. Bad debt expense is something that must be recorded and accounted for every time a company prepares its financial statements. When a company decides to leave it out, they overstate their assets, and they could even overstate their net income. For example, in one accounting period, a company can experience large increases in their receivables account. Then, in the next accounting period, a lot of their customers could default on their payments (not pay them), thus making the company experience a decline in its net income.

Understanding Post-Closing Trial Balances in Accounting

Another category might be 31–60 days past due and is assigned an uncollectible percentage of 15%. All categories of estimated uncollectible amounts are summed to get a total estimated uncollectible balance. That total is reported in Bad Debt Expense and Allowance for Doubtful Accounts, if there is no carryover balance from a direct write-off method prior period. If there is a carryover balance, that must be considered before recording Bad Debt Expense. The balance sheet aging of receivables method is more complicated than the other two methods, but it tends to produce more accurate results.

Reasons Why it is not preferred in the Accounting Profession?

Failing to do so means that the assets and net income may be overstated. If your small business accepts credit sales, you run the risk of encountering something called a “bad debt expense.” Bad debt expenses are outstanding accounts that, after going unpaid, are deemed uncollectible. A bad debt expense, also called a doubtful debt, is a portion of accounts receivable that your business assumes you won’t ever collect. These expenses are recorded as a negative transaction on your business’s financial statements.

• If there is a carryover balance, that must be considered before recording Bad Debt Expense.
• Under this approach, businesses find the estimated value of bad debts by calculating bad debts as a percentage of the accounts receivable ending balance.
• Not being able to collect payments when you provide a good or service can slow down your cash flow.
• This method offers a more predictive framework, allowing businesses to estimate uncollectible accounts in advance.
• The accounts receivable method is considerably more sophisticated and takes advantage of the aging of receivables to provide better estimates of the allowance for bad debts.
• The direct write-off method is one of two ways to account for bad debt.

Under this method, bad debt is recognized and written off only when it is retained earnings determined to be uncollectible. When a specific account is identified as bad debt, the company records a bad debt expense and reduces accounts receivable by the same amount. In the allowance method, businesses create an allowance for doubtful accounts, which serves as a contra-asset account on the balance sheet. This account estimates the amount of accounts receivable that may not be collected.