2. Direct Method

Let's talk about the direct write-off method. Before we get started, I want you to know that the direct write-off method is not used really. This is not one that you're gonna have to worry about too much. First of all, it's simple. Second of all, you actually use the allowance method in about, I don't know, over 95% of the cases. The direct write-off method can only be used if accounts receivable is immaterial.

Immaterial meaning it doesn't really matter. You can only use the direct write-off method if accounts receivable is so small that should you mess it up, should you even leave it off the balance sheet, it doesn't make that much of a difference. So as you can bet, the direct write-off method is not used very often. Most of your companies and most of your chapter and your test actually is gonna involve the allowance method because it follows GAAP principles much closer. So know all of that up front, but you may still have a question or two on the direct write-off method. So let's talk about that.

Let me give you a scenario. At some point in time, we make a sale, and we record accounts receivable. At some other point in time, the customer goes bankrupt. Let's say it's $500. Somewhere in the middle, we have the end of the year, and this should show you why the direct write-off method doesn't follow the GAAP principles very closely. So this is Year 1. This is Year 2. And under the direct write-off method, you directly and specifically write accounts off. Now, what does it mean to write something off? Well, it means the exact same thing as it means in the real world.

When you write somebody off or when you write something off in the real world, you're basically saying, "Yeah, they're not valuable. They're not important. That thing, whatever it is, it's not important. I'm just gonna write it off." And that's the same thing in accounting. When we write it off, we are acknowledging not valuable. So let me show you the entries under the direct write-off method. In Year 1, you make an entry that increases accounts receivable and increases sales revenue. This is sometime in Year 1. Then in Year 2, you do your write-off. You say, "You know what? That customer just went bankrupt. We're not ever gonna get paid."

That's your write-off right there. You are decreasing your accounts receivable. You're saying, "I am not going to receive that account." And the place we put it in the direct write-off method is in a bad debt expense of $500. So you credit your accounts receivable to take it down, and you debit a bad debt expense to increase it. Now, what's the problem here? The problem here is that this expense was actually incurred in Year 1, wasn't it? Wasn't that expense incurred when we made that sale? So then at 12/31, we have two problems. One is that we didn't match this expense to Year 1, and the second problem is that we overstated our accounts receivable.

We didn't conservatively state our accounts receivable to allow for this bad debt expense to happen later. So you can see this is why the direct method can only be used when accounts receivable are small and irrelevant, basically. Because if you had a sale in Year 1, and then in Year 5 you had to write off the sale, well, this expense should've been way back here, but it's all the way out here. And so you're not following the matching principle at all. So I don't want you to spend too much time worrying about this. I'm purposefully not even gonna talk too much about bad debt expense in this video because the real stuff is in this allowance method.

That's where we get into the really good stuff. And there, you're gonna learn more about bad debt expense than you ever wanted to.