Why direct write-off breaks matching; the income-statement approach ignores the balance

Some of them will not pay

A company that sells on account knows from experience that a small share of its receivables will never be collected. It does not know which customers — if it did, it would not have sold to them. The question is when to record the loss.

Direct write-off waits until a specific customer is known to have failed, then expenses that account: Dr Bad Debts Expense / Cr Accounts Receivable. Simple, and wrong under ASPE for any company with material receivables, for two reasons. It breaks matching: the sale was revenue of year 1, and the failure is discovered in year 2, so year 1's income is overstated and year 2's is charged with year 1's cost of selling on credit. And it overstates the asset: until the failure is discovered, receivables are shown at their face amount when the company already knows some of that will not arrive.

The allowance method estimates the uncollectible portion in the period of the sale and records it then, against a contra-asset account — Allowance for Doubtful Accounts — so that receivables are shown at what will actually be collected, their net realisable value:

Accounts receivable                      148,000
Less allowance for doubtful accounts     (10,900)
Accounts receivable, net                 137,100

The allowance is not cash set aside. It is a valuation account with a credit balance, exactly like Accumulated Amortization: it reduces the asset to what it is worth without touching the individual customer accounts, because nobody yet knows whose account will fail.

Worked example — Bramble Lane, the income-statement approach

The estimate can be built from the income statement or from the balance sheet. The income-statement approach asks: of this year's credit sales, what share will go bad? Bramble Lane's credit sales were 640,000 and its history says 1.5 % is never collected:

$$\text{Bad debts expense}=640,000\times 1.5\%=9,600$$

Dec 31  Bad Debts Expense                  9,600
            Allowance for Doubtful Accounts          9,600

The credit goes to the allowance, never to Accounts Receivable — no specific customer has failed. And the entry is 9,600 regardless of what the allowance already holds. If the allowance carried a 1,300 credit from last year, it now holds 10,900; if it carried a debit (last year's write-offs exceeded last year's estimate), it holds 9,600 less that debit. The method matches a percentage of sales to the sales; the existing balance is last year's business and is left alone. Adjusting for it is the other method, L7.5's — and mixing the two is the commonest error on this family.

Harrowgate, the same way: credit sales 150,000 at 2 % → 3,000, with the allowance currently a 700 debit. The expense is still 3,000 — not 3,700. After posting, the allowance holds a 2,300 credit.

On the balance sheet

Accounts receivable is shown net — gross less the allowance — with both figures visible, the way PP&E shows cost less accumulated amortization (L6.5). Bad Debts Expense is an operating expense on the income statement, in the year of the sales it belongs to.