Direct write-off mostly refers to the recording of uncollectible accounts receivable. Companies often make credit sales and retain accounts receivable, expecting to collect them from customers over time. However, certain accounts receivable may become uncollectible at some point. Companies can either estimate at the time of the credit sales the amount of accounts receivable that may be at risk or directly write off any uncollected accounts receivable later as it happens. The direct write-off method is simple and factual, involving no estimates. But it does have certain disadvantages in reporting the bad debt expense and accounts receivable value, as well as earnings in general.
Uncollectible Accounts
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It's a common practice that at the time of the credit sales, companies make estimates about the percentage of total accounts receivable that may prove to be uncollectible at a later time. Companies then indirectly set up an allowance for doubtful accounts as a negative account to accounts receivable and meanwhile record a bad-debt expense in the period when the sales occur. Using the direct write-off method, however, companies record a bad-debt expense only when certain accounts receivable have become actually uncollectible.
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Mismatched Expense
Any bad-debt expense as a result of the uncollected accounts receivable is associated with the original credit sales. But using the direct write-off method, companies would not record a bad-debt expense until a later period when they deem certain accounts receivable as uncollectible. Consequently, the bad-debt expense is inappropriately recorded against the revenue of sales from a later period, mismatching the bad-debt expense with the revenue of the original credit sales.
Overstated Receivable
Accounts receivable is an asset account, and companies report the value of accounts receivable differently under the indirect allowance method and the direct write-off method. With the account of allowance for doubtful accounts, companies report the carrying value of accounts receivable net of the amount of allowance, reflecting the true, realizable value of the accounts receivable. Using the direct write-off method, companies overstate the value of accounts receivable when certain accounts receivable have become uncollectible but have not been written off.
Manipulated Earnings
Unlike the allowance method that records the estimated uncollectible accounts receivable at the time of the sales, the direct write-off method allows companies to select the period in which they would like to write off any uncollectible accounts receivable, potentially causing earnings manipulation. If earnings are down, companies may delay any write-off of uncollectible accounts receivable to avoid further decrease in reported earnings. Because of such a drawback in using the direct write-off method, the method often is not used except when the amount uncollectible is immaterial.