A write off is an elimination of uncollectible accounts receivable recorded on the general ledger. An accounts receivable balance represents an amount due to Cornell University. If the individual is unable to fulfill the obligation, the outstanding balance must be written off after collection attempts have occurred.
Definition of Bad Debts
The term bad debts usually refer to accounts receivable (or trade accounts receivable) that will not be collected. (Bad debts are also used for notes receivable that will not be collected.)
The bad debts associated with accounts receivable are reported on the income statement as Bad Debts Expense or Uncollectible Accounts Expense.
Writing Off Uncollectable Receivables
Definition of Bad Debts Expense
Bad debts expense is related to a company’s current asset accounts receivable. Bad debts expense is also referred to as uncollectible accounts expense or doubtful accounts expense. Bad debts expense results because a company delivered goods or services on credit and the customer did not pay the amount owed.
The allowance method anticipates and estimates that some of the accounts receivable will not be collected. In other words, prior to knowing exactly which customers or clients will not be paying, the company will debit Bad Debts Expense and will credit Allowance for Doubtful Accounts for the estimated amount.
Examples of Bad Debts Expense
There are two methods for reporting the amount of bad debts expense:
- direct write-off method
- allowance method
The direct write-off method requires that a customer’s uncollectible account be removed from Accounts Receivable and at that time the following entry is made: debit Bad Debts Expense and credit Accounts Receivable.
Definition of Direct Write-off Method
The direct write-off method is one of the two methods normally associated with reporting accounts receivable and bad debts expense. (The other method is the allowance method.)
Under the direct write-off method, bad debts expense is first reported on a company’s income statement when a customer’s account is actually written off. Often this occurs many months after the credit sale was made and is done with an entry that debits Bad Debts Expense and credits Accounts Receivable.
With the direct write-off method, there is no contra asset account such as Allowance for Doubtful Accounts. Therefore the entire balance in Accounts Receivable will be reported as a current asset on the company’s balance sheet.
As a result, the balance sheet is likely to report an amount that is greater than the amount that will actually be collected. It can also result in the Bad Debts Expense being reported on the income statement in the year after the year of the sale.
For these reasons, the accounting profession does not allow the direct write-off method for financial reporting. Instead, the allowance method is to be used for the financial statements.
Once authorization has been granted for a write-off, the requesting unit will process a Distribution of Income and Expenses (DI) e-doc with the following entries:
- DR(to) Departmental Account number and object code 6330 – Bad Debt Expense
- CR (from) Departmental Account number and accounts receivable object code
- A different entry is needed for units that maintain an allowance for doubtful accounts:
- DR(to) Departmental Account number and object code 1250 Allowance for Doubtful Accts
- CR (from) Departmental Account number and accounts receivable object code
The documentation submitted for authorization must be attached to the e-doc.
Accounting will conduct a post-audit review of object code 6330 to ensure that it is used in conjunction with an appropriate offsetting account receivable or accounts receivable allowance object code.
Write off accounts receivable journal entry
When the company writes off accounts receivable under the allowance method, it can make journal entries by debiting allowance for doubtful accounts and crediting accounts receivable.
|Allowance for doubtful accounts||000|
Under the allowance method, a company anticipates that some of its credit sales and accounts receivable will not be collected and establishes an Allowance for Doubtful Accounts prior to knowing the specific account or accounts that will become uncollectible. The Allowance account is established and adjusted with the following journal entry:
- Debit Bad Debts Expense, and
- Credit Allowance for Doubtful Accounts
When a specific customer’s account is identified as uncollectible, the journal entry to write off the account is:
- A credit to Accounts Receivable (to remove the amount that will not be collected)
- A debit to Allowance for Doubtful Accounts (to reduce the Allowance balance that was previously established)
Note that under the allowance method the write-off did not affect an income statement account. The income statement account Bad Debts Expense was affected earlier when the Allowance balance was established or adjusted.
For financial reporting purposes, the allowance method is preferred since it means the loss (bad debts expense) is recognized closer to the time of the credit sales. This also means that the balance sheet will be reporting a lower, more realistic amount of its accounts receivable sooner.
However, the direct write-off method must be used for U.S. income tax reporting. Apparently, the Internal Revenue Service does not want a company reducing its taxable income by anticipating an estimated amount of bad debts expense (which is what happens when using the allowance method).
For example, on September 05, 2020, the company ABC Ltd. decide to write off Mr. D’s account with the receivable balance of USD 2,000.
In this case, the company can make the journal entry of accounts receivable write-off as below:
|Allowance for doubtful accounts||2,000|
It is useful to note that after writing off accounts receivable, the balance of allowance for doubtful accounts, which is on the credit side in nature, may stay on the debit side instead. This is a case in which the write-off amount is more than the balance of allowance doubtful accounts.
However, the balance will be back to be normal after adjusting entry for bad debt because the company will add the debit balance to the required balance in the adjusting entry.
For the example above, assume the company ABC Ltd. had the allowance for doubtful accounts of USD 1,500 on the credit side before writing off Mr. D’s account. Hence, the allowance account after writing off will remain as a debit balance of USD 500 (2,000-1,500).
Assuming the estimated losses from bad debt at the year-end of 2020 is USD 3,000, the company will need to make an allowance for doubtful accounts of USD 3,500 (3,000 + 500) in the adjusting entry. This is due to the company need to add the debt balance of USD 500 on to the required balance of USD 3,000.
Hence, the adjusting entry for the estimated losses from bad debt will be with the USD 3,500 instead of USD 3,000 as below:
|Bad debt expense||3,500|
|Allowance for doubtful accounts||3,500|
Direct write off method
Direct write-off method is usually only be used by the company that has only a small amount of credit sales or an insignificant balance of receivables. In this method, the company does not make an estimation of bad debt for adjusting entry, so no allowance for doubtful accounts is created.
|Bad debt expense||000|
For example, the company XYZ Ltd. decides to write off accounts receivable of Mr. Z that has a balance of USD 300.
In this case, the company can make the journal entry of the written-off receivables under the direct write off method as below:
|Bad debt expense||300|
|Accounts receivable – Mr. Z||300|
Under the direct write-off method, a company writes off a bad account receivable when a specific account is determined to be uncollectible. This usually occurs many months after the credit sale occurred. The entry to write off the bad account under the direct write-off method is:
- Debit Bad Debts Expense (to report the amount of the loss on the company’s income statement)
- Credit Accounts Receivable (to remove the amount that will not be collected)
In the U.S., the direct write-off method is required for income tax purposes but is not the method to be used for a company’s financial statements.
It is useful to note that the direct write-off method does not conform to the matching principle of accounting. Hence, we may not come across such a method in the company that follows acceptable accounting standards.