The direct write-off method refers to an accounting practice used by companies in reporting payments from other parties that are considered noncollectable. When this occurs, the payment, which was once considered revenue, is converted to an expense and thereby written off as such by the company for tax purposes. Using the direct write-off method, companies record the expense at the time when the payment is considered noncollectable rather than at the time the revenue was recorded. This practice can be problematic when the amounts involved are significant, since it violates the accounting standard of matching revenues and expenses at the times they are actually realized.
Many modern business transactions occur in the form of credit arrangements between two companies. For example, one company may serve as a vendor for another company, and the vending company may offer the goods to the receiving company on credit, allowing payment to be made at a later date. In certain cases though, one party may renege on their payment obligations, either due to financial troubles or simply through its own unscrupulousness. When this occurs, the company that loses out on the promised payment must account for its loss, and one way to do so is through the direct write-off method.
Using the direct write-off method, a company, having finally given up on hope of ever receiving a specific payment, will include the payment in its expenses. The entry in the accounting statements will be listed as an noncollectable accounts expense. This expense balances out the amount recorded as revenue when the purchase was originally made.
Companies that use the direct write-off method should only try to do so for those accounts that aren't significant to its overall financial status. Should the amount of uncollected receivables reach a substantial amount, the direct method can provide an imbalanced look at the company's actual financial strength. Assuming that all credit arrangements will be met is naive, and a company may wish to use the allowance method of accounting for a more realistic depiction of noncollectable accounts instead.
In contrast to the direct write-off method, which does not follow the matching principle of accounting, the allowance method writes off a certain percentage of its receivables as expenses in each accounting period. By doing this, the company is providing a more accurate representation of the money it is actually receiving from its credit accounts. The allowance method also adheres more strictly to the matching principle, even though it is impossible to predict exactly which receivables will be left unpaid in the future.
