In most cases, companies that offer credit sales, have customers not capable of repaying their debt. Companies develop a variety of collection methods to secure payments; however, some accounts will remain uncollected. The two primary methods used by companies to document uncollectible accounts are the direct write-off and percentage of sales method. Both methods have advantages, and disadvantages and it is the owners’ decision to choose the method that will be beneficial to their company. The direct write-off method entails a company immediately writing off bad debt from their AR once it is identified, but this is considered a violation because it is not cohesive with the GAAP. When companies use this method, the invoice is expensed in the accounting period in which the debt was identified as uncollectible. As a result, companies use this method with inconsequential accounts they know they cannot collect. For example, a subprime auto lender may record $25,000 in credit sales in January and not expense the account as a bad debt until July. In the journal entry it will be dr. to uncollectible account expense and a cr. to accounts receivable. An advantage of using direct write-off is its simplicity, and there are no adjusted entries at the end of the financial quarter. On the other hand, a disadvantage is that it fails to adhere to the matching principle, which indicates that revenue and expenses must be recorded in the same period. Failure to follow the matching principle leads to incorrect recording of inflow and outflow on financial statements. This method also leaves a window of opportunity for managers to manipulate earnings because they can choose which accounting periods to record bad debt. The percentage of sales is also known as the allowance method. When managers use this method they estimate the percentage of AR or credit sales there are not likely to collect by evaluating the customer’s credit rating, and historical data. Once the write-off amount is determined the first journal entries will include a dr. to uncollectible account expense, and a cr. to allowances for doubtful accounts. Over time if an account is recognized as completely uncollectible, a dr. is made to allowances for doubtful accounts and a cr.
