Understanding Bad Debt and the Methods to Write it Off

✍️Creditors have to deal with uncollectible accounts and recognize losses by writing off bad debts.

💡The allowance method is the only method that complies with GAAP for bad debt write-offs.

🔄The direct write-off method is not allowed under GAAP but may be used by smaller businesses.

💸The direct write-off method should only be used for non-material accounts receivable write-offs.

🔁When a written-off account is unexpectedly paid later, it requires two sets of journal entries to reinstate the account and record the receipt of cash.

What is bad debt?

—Bad debt refers to the amount that a creditor cannot collect from a debtor. It results in recognizing a loss for the uncollectible amount.

What are the methods used to write off bad debts?

—The two methods used to write off bad debts are the allowance method and the direct write-off method. The allowance method is the preferred method as it complies with GAAP.

What is the allowance method?

—The allowance method is a method of estimating and recognizing bad debts by creating an allowance for doubtful accounts. This allowance is based on historical data and expected credit losses.

Why is the direct write-off method not allowed under GAAP?

—The direct write-off method is not allowed under GAAP because it violates the matching principle and lacks the necessary accuracy and reliability required by accounting standards.

What happens when a written-off account is unexpectedly paid later?

—When a written-off account is unexpectedly paid later, it requires two sets of journal entries. The first entry reinstates the customer's account receivable balance and reverses the bad debt expense. The second entry records the receipt of cash.

00:00Introduction to bad debt and the need to write off uncollectible accounts.

00:21Explaining the two methods used to write off bad debts: the allowance method and the direct write-off method.

01:52Comparing the allowance method and the direct write-off method, highlighting the compliance with GAAP.

02:45Discussing the limitations of the direct write-off method and its usage by larger companies in non-material write-offs.

03:41Explaining the process of reinstating a written-off account when it is unexpectedly paid later.