- Apply the direct write-off method of accounting for bad debts
At the end of October, NeatNiks’s accounts receivable ledger page looked like this:
| Date | Item | Post. Ref. | Debit | Credit | Balance | ||
|---|---|---|---|---|---|---|---|
| Debit | Credit | ||||||
| 20– | |||||||
| Oct | 1 | Balance | a | 0.00 | |||
| Oct | 20 | GJ1 | 7,250.00 | 7,250.00 | |||
| Oct | 30 | GJ2 | 1,600.00 | 5,650.00 | |||
And the subsidiary ledger total matched the control account:
Oct.30payment on account
600.001,900.00
| Date | Item | Post. Ref. | Debit | Credit | Balance | ||
|---|---|---|---|---|---|---|---|
| Debit | Credit | ||||||
| 20– | |||||||
| ABE | |||||||
| Oct. | 20 | cleaning inv. NN1016 | 1,000.00 | ||||
| Oct. | 30 | payment on account | 1,000.00 | 0.00 | |||
| MPAC | |||||||
| Oct. | 20 | cleaning inv. NN1019 | 1,750.00 | 1,750.00 | |||
| National City | |||||||
| Oct. | 20 | cleaning inv. NN1017 | 2,500.00 | ||||
| Our Town Properties | |||||||
| Oct. | 20 | cleaning inv. NN1018 | 2,000.00 | 2,000.00 | |||
| Total | 5,650.00 | ||||||
Both ledgers, the general (control) and the subsidiary (detail) are created from the same journal entries that are created from the same source data, so they always, always have to match perfectly. In this case, they show our customers owe us $5,650 for work we have done.
Let’s say in November we discover Our Town Properties went out of business and we decide there is no hope we will collect any of the $2,000 it owes us. In reality, we wouldn’t give up that fast—we’d be attempting to collect for months, Our Town Properties would file for bankruptcy, and there would be a waiting period, etc. But for illustration purposes, let’s just say our customer just packed up and disappeared.
We would “write off” the account. We don’t reduce revenue because we earned that $2,000. Instead, we create an expense account called Bad Debt Expense, and we make the following entry (most likely an adjusting journal entry at the end of November):
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| 20– | ||||
| Nov 30 | Bad Debt Expense | 550 | 2,000.00 | |
| Nov 30 | Accounts Receivable | 120 | 2,000.00 | |
| Nov 30 | To write off Our Town Properties receivable |
Once we post this entry, we see the following in the GL control account (we’re ignoring the fact there would be a host of other transactions in November):
| Date | Item | Post. Ref. | Debit | Credit | Balance | ||
|---|---|---|---|---|---|---|---|
| Debit | Credit | ||||||
| 20– | |||||||
| Oct | 1 | Balance | a | 0.00 | |||
| Oct | 20 | GJ1 | 7,250.00 | 7,250.00 | |||
| Oct | 30 | GJ2 | 1,600.00 | 5,650.00 | |||
| Nov | 30 | GJ3 | 2,000.00 | 3,650.00 | |||
And we update the subsidiary ledger as well:
Oct.30payment on account
600.001,900.00
Nov30account written off
2,000.000.00
| Date | Item | Post. Ref. | Debit | Credit | Balance | ||
|---|---|---|---|---|---|---|---|
| Debit | Credit | ||||||
| 20– | |||||||
| ABE | |||||||
| Oct. | 20 | cleaning inv. NN1016 | 1,000.00 | ||||
| Oct. | 30 | payment on account | 1,000.00 | 0.00 | |||
| MPAC | |||||||
| Oct. | 20 | cleaning inv. NN1019 | 1,750.00 | 1,750.00 | |||
| National City | |||||||
| Oct. | 20 | cleaning inv. NN1017 | 2,500.00 | ||||
| Our Town Properties | |||||||
| Oct. | 20 | cleaning inv. NN1018 | 2,000.00 | ||||
| Total | 3,650.00 | ||||||
We also have an expense account now called Bad Debt Expense with a debit balance of $2,000 that will act as an offset of November revenues when we calculate net income.
Note that you should be calling both MPAC and National City at this point to ask for payment or to make other arrangements. Normal business practice is to require payment within 30 days (called “net 30”), but it’s also possible NeatNiks is allowing 45 days or even 60 days to pay. In any case, by the end of November, the October revenues should be mostly collected.
Writing off a bad account when its uncollectibility is certain is called the direct write-off method.
This is the method required by the Internal Revenue Code (as of 2020—of course, this could change at some point). The drafters of the IRC wanted to make sure companies weren’t trying to manipulate taxable income by writing off accounts that weren’t really uncollectible. This practice makes sense, except that accrual basis income requires matching revenues and expenses, and the direct write-off method is a violation of that principle. In this case, we recognized revenue in October, but then recognized the expense in November. This difference isn’t critical if we are looking at net income on an annual basis, but if we are analyzing net income monthly, it can skew our results. For example, if large companies recognize revenue in 2020, and then recognize the bad debts in 2021 or even 2020 when they are identified, those companies are definitely violating the matching principle.
How can we match bad debt expense to revenue when we don’t yet know which revenues are going to be uncollectible?
The Financial Accounting Standards Board (FASB) came up with GAAP to address this issue. But before we discuss that issue, it’s time to check your understanding of the direct write-off method of accounting for bad debts.