What is the Direct Write-Off Method?

Under the direct write-off method, a bad debt is charged to expense as soon as it is apparent that an invoice will not be paid. This is the simplest way to recognize a bad debt, since the entry is only made when a specific customer invoice has been identified as a bad debt. This method is commonly used by smaller businesses.

What is the Allowance Method?

Under the allowance method, an estimate of the future amount of bad debt is charged to a reserve account as soon as a sale is made. This means that the expense is paired with the sale, so that all expenses related to the sale are reported in the same period as the sale. It is the most theoretically correct way to deal with bad debts. However, it requires an estimate of bad debts, rather than the specific identification of bad debts, and so can be less accurate than the direct write-off method.

The Difference Between the Direct Write-Off and Allowance Methods

There are several differences between the direct write-off and allowance methods, which are outlined below:

Timing differences. Bad debt expense recognition is delayed under the direct write-off method, while the recognition is immediate under the allowance method. This results in higher initial profits under the direct write-off method, though the profits reported in later periods will reduced.
Matching principle compliance. The direct write-off method does not comply with the matching principle, since not all expenses associated with a revenue event are being recognized in the same period as the revenue. Conversely, the allowance method does comply with the matching principle.
Accuracy differences. The exact amount of the bad debt expense is known under the direct write-off method, since a specific invoice is being written off, while only an estimate is being charged off under the allowance method.
Receivable line item differences. The receivable line item in the balance sheet tends to be lower under the allowance method, since a reserve is being netted against the receivable amount.