Your company has essentially two choices in accounting for bad debts: Direct Write Off Method or Allowance Method. We’ll look at both methods with the advantages and disadvantages of each.
DIRECT WRITE OFF METHOD
The Direct Write Off Method simply means that bad debts are written off the balance sheet (subtracted from accounts receivable) and income statement (recorded as bad debt expense) at the time they are deemed uncollectible.
The advantage to this method is its simplicity. You only deal with a bad debt on the books when it actually occurs. There are, however, several disadvantages to the direct writeoff method.
The first difficulty is determining when the account is actually uncollectible. To be on the safe side, check with your CPA for IRS guidelines. The other disadvantage to this method is that large bad debts hit the income statement all at one time which can cause a large loss in one particular month. This could have a negative impact on suppliers or banks receiving your financial statements.
ALLOWANCE METHOD
The allowance method for bad debt allows you to expense a certain amount each month off your income statement and create a “contra” allowance account against your accounts receivable. When bad debts actually occur, the allowance account is debited. There is no effect on your income statement for that month.
The advantage to this method is that it spreads bad debt expense over all 12 months of operations at an even level. Assuming your company is profitable, the allowance method reduces taxable income and therefore saves taxes year round. Again, be sure to check with your CPA regarding IRS rules for allowable amounts. Basically, the IRS says the amount of the allowance account must be reasonable based on your bad debt history.
The primary disadvantage to the allowance method is the extra accounting involved. This method can also be difficult on a company who already has losses or is only earning small profits.
We suggest you review you past few years bad debt history and take a hard look at your delinquent receivables. Then talk to your CPA about which method might be most appropriate for your business this year.
