The direct write off method involves charging bad debts to expense in the period when individual invoices have been clearly identified as bad debts. The specific action used to write off an account receivable under this method with accounting software is to create a credit memo for the customer in question, which offsets the amount of the bad debt. Creating the credit memo creates a debit to a bad debt expense account and a credit to the accounts receivable account.
The method does not involve a reduction in the amount of recorded sales, only the increase of the bad debt expense. For example, a business records a sale on credit of $10,000, and records it with a debit to the accounts receivable account and a credit to the sales account. After two months, the customer is only able to pay $8,000 of the open balance, so the seller must write off $2,000. It does so with a $2,000 credit to the accounts receivable account and an offsetting debit to the bad debt expense account. Thus, the revenue amount remains the same, the remaining receivable is eliminated, and an expense is created in the amount of the bad debt.
The direct write off approach violates the matching principle, under which all costs related to revenue are charged to expense in the same period in which you recognize the revenue, so that the financial results of an entity reveal the entire extent of a revenue-generating transaction in a single accounting period.
The direct write off method delays the recognition of expenses related to a revenue-generating transaction, and so is considered an excessively aggressive accounting method, since it delays some expense recognition, making a reporting entity appear more profitable in the short term than it really is. For example, a company may recognize $1 million in sales in one period, and then wait three or four months to collect all of the related accounts receivable, before finally charging some items off to expense. This creates a lengthy delay between revenue recognition and the recognition of expenses that are directly related to that revenue. Thus, the profit in the initial month is overstated, while profit is understated in the month when the bad debts are finally charged to expense.
The direct write off method can be considered a reasonable accounting method if the amount that is written off is an immaterial amount, since doing so has minimal impact on an entity's reported financial results, and so would not skew the decisions of a person using the company's financial statements.
The alternative to the direct write off method is to create a provision for bad debts in the same period that you recognize revenue, which is based upon an estimate of what bad debts will be. This approach matches revenues with expenses, and so is considered the more acceptable accounting method.
The direct write off method is required for the reporting of taxable income in the United States, since the Internal Revenue Service believes (possibly correctly) that companies would otherwise be tempted to inflate their bad debt reserves in order to report a smaller amount of taxable income.
The direct write off method is also known as the direct charge-off method.