What is the direct write-off method in business? Plus example

By Indeed Editorial Team

Published 25 July 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

The direct write-off method helps organisations effectively recognise and manage bad debt. This refers to debt or money owed by customers for a good or service already provided, and are unable to pay the remaining balance. You may also refer to this balance as uncollectible receivables, or an amount of money owed to your business that accumulates into uncollected payments. In this article, we discuss what the direct write-off method is, how it can help your business and how you can begin effectively using it to manage your company's bad debt.

What is the direct write-off method?

The direct write-off method is an accounting process that provides your company with the ability to write off uncollectible accounts receivable as bad debt. Your company can generally debit your bad debts expense account and credit your accounts receivable. This method turns bad debt into a revenue expenditure that you can then deduct from your company's taxes, so long as it conforms to standard practices for accounting. A financial institution may recognise these expenditures as part of the regular loan relationships they establish as part of their processes for loan validation and reconciliation.

Also, understand that the direct write off method violates the matching principle of Generally Accepted Accounting Principles in the UK (UK GAAP), which states that your company should report expenses during the period you incur them. It may take several months for your company to write off this account as bad debt after initially reporting it. Your company can then adjust for the time period between the initial transaction and your bad debt expenditure. In the event that the debtor decides to pay the amount later on, your company can debit accounts receivable and reduce the bad debt expense.

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Usage of the direct write-off method

As you manage your company's finances, the overdue and uncollected accounts create an obstacle to making quarterly and annual goals. The direct write-off method offers an option to address these issues as they arise. When your company creates the initial balance on an account, recognise that the account holder may not be able to pay the account. When you make attempts to collect on an account, keep an accurate record of the steps you take and any attempted correspondence with the account holder.

If that account holder still cannot pay the amount after several months, take the initiative to credit your accounts receivable for the amount. You can then put those into an account set aside specifically for bad debt expenses. Now, you can pull that account along with your other financial records to have a more thorough understanding of your company's financial health. When filing taxes, you can pull the exact amount from that account for your records and write it off with the HM Revenue & Customs.

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Direct write-off vs allowance

The primary differences between the direct write-off method and the allowance method are how soon you adjust for bad debt and the precision of accounting. The direct write-off method addresses discrepancies with exact amounts as soon as the company realises that they have uncollected debt. In contrast, the allowance method addresses these discrepancies at the end of the fiscal year with an estimated sum for the company's bad debt. This means the direct write-off method makes your financial reporting more accurate, improves your understanding of your organisation's financial health and saves your accounting department time in addressing discrepancies.

When a business uses the allowance method, they review all open accounts at the end of the fiscal year and estimate how many of those accounts will go unpaid. They often use past figures of uncollected accounts to find a percentage they can measure against the accounts that are currently open. The company can then create a separate account for allowances and debit the estimated amount to their bad debts expenses account. Small businesses often benefit from the direct write-off method of reviewing their finances for a given period, setting goals for their business and filing their taxes.

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Advantages of the direct write-off method

When owning a business, it's important to understand the direct write-off method and its benefits. It can improve your accounting practices and help your company manage the debts to your company that will remain unpaid. While ideal business practices recognise bad debts as an irregularity, your company may encounter them regularly and should have an adopted method of addressing them. Here are some of the advantages of using this method:

Simplicity

The direct write-off method is a simple option to adjust and account for bad debts with only two transactions. These are the charges to accounts receivable for the amount the customer owes and to your company's bad debts expenses account. Tracking only these two transactions simplifies the processes of balancing payments and filing taxes. In contrast, the allowance method of accounting requires you to regularly report bad debt expenses and adjust your company's reserve funds.

Related: Complete Guide: What Is Accounts Receivable

Tax write-off

Companies with bad debt expenses can write them off from their taxable income on their annual tax returns. Though the direct write-off method doesn't follow the UK GAAP, the HM Revenue & Customs requires companies to use this method for their tax returns. The allowance method cannot write off bad debt under these circumstances as it does not meet the HM Revenue & Customs requirements for accurately calculating tax deductions.

Precise amounts

The direct write-off method accounts for exact amounts of money transferred between the two adjustment transactions. This helps your company avoid any errors in accounting and reduces the risk of overstating any projected expenses. The allowance method uses estimates of the amounts transferred, as it refers solely to a reserve fund previously set aside for discrepancies such as these.

Related: How to become a tax accountant

Disadvantages of the direct write-off method

Just as the direct write-off method can be helpful for your business, there may also be potential drawbacks you should understand. These are simple by-products of your company creating two additional charges to your accounts that your company normally would not have. Think of them as obstacles for your accounting department to overcome as they balance your books and report their financial records to the HM Revenue & Customs. Here are some disadvantages of using the direct write-off method:

Violates the matching principle

As mentioned, the use of the direct write-off method violates the matching principle. The matching principle states that a company should report all expenses in the same period the company accrues said expenses. A direct write-off typically happens in a different year than when the initial charge occurs. As you cannot predict bad debts beforehand, the company cannot accurately account for them until the following period. For example, if your business completes a transaction at the end of one accounting period ending in December, you might not realise the bad debts until the beginning of March.

Balance sheet inaccuracy

Another disadvantage includes the balance sheet. Since using this method means crediting accounts receivable, it can give a false sense of a company's accounts. Your financial statements may not accurately portray the company's finances as a result of the two additional transactions. This means that it works differently than the UK GAAP, due to the possible balance sheet inaccuracies. The HM Revenue & Customs does recognise discrepancies due to bad debt and acknowledges the direct write-off method as a means to account for bad debts.

Overstates accounts receivable

Using this method, your business reports the full amount of initial transactions as accounts receivable. If these accounts remain uncollected, your company would report your accounts receivable as higher than what is accurate for your company at that time. This requires accurate reporting and a fundamental understanding of these discrepancies and where they come from as your company's accounting department balances these accounts against your financial statements.

Related: How to become a tax manager: a step-by-step guide

Direct write-off example

Consider the following example as you evaluate your company's accounting needs:

You make a cake for a couple's wedding and then send them an invoice for £600 after finishing the cake. You credit £600 to your company's revenue and make a debit entry of £600 to accounts receivable. After a few months of trying to collect on the £600 invoice, you come to the realisation that you won't be paid for your services.

After your unsuccessful attempts to collect the sum, you deem it uncollectible and record it as a bad debt. Using the direct write-off method, you debit the bad debt expense account for £600 and credit £600 to accounts receivable. This would reverse the first transaction and complete the method.

Related:

  • What is account reconciliation? (Balances and discrepancies)


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