The companies that qualify for this exemption, however, are typically small and not major participants in the credit market. Assuming that credit is not a significant component of its sales, these sellers can also use the direct write-off method. The final point relates to companies with very little exposure to the possibility of bad debts, typically, entities that rarely offer credit to its customers. For example, if the company wanted the deduction for the write-off in 2018, it might claim that it was actually uncollectible in 2018, instead of in 2019. This application probably violates the matching principle, but if the IRS did not have this policy, there would typically be a significant amount of manipulation on company tax returns. Because of this potential manipulation, the Internal Revenue Service (IRS) requires that the direct write-off method must be used when the debt is determined to be uncollectible, while GAAP still requires that an accrual-based method be used for financial accounting statements.įor the taxpayer, this means that if a company sells an item on credit in October 2018 and determines that it is uncollectible in June 2019, it must show the effects of the bad debt when it files its 2019 tax return. This variance in treatment addresses taxpayers’ potential to manipulate when a bad debt is recognized. For example, when companies account for bad debt expenses in their financial statements, they will use an accrual-based method however, they are required to use the direct write-off method on their income tax returns. It is important to consider other issues in the treatment of bad debts. This matching issue is the reason accountants will typically use one of the two accrual-based accounting methods introduced to account for bad debt expenses. The direct write-off method would record the bad debt expense in 2019, while the matching principle requires that it be associated with a 2018 transaction, which will better reflect the relationship between revenues and the accompanying expenses. For example, assume that a credit transaction occurs in September 2018 and is determined to be uncollectible in February 2019. Under generally accepted accounting principles ( GAAP), the direct write-off method is not an acceptable method of recording bad debts, because it violates the matching principle. Once this account is identified as uncollectible, the company will record a reduction to the customer’s accounts receivable and an increase to bad debt expense for the exact amount uncollectible. The direct write-off method delays recognition of bad debt until the specific customer accounts receivable is identified. (credit: modification of “Past Due Bills” by “Maggiebug 21”/Wikimedia Commons, CC0) Uncollectible customer accounts produce bad debt. There are two methods a company may use to recognize bad debt: the direct write-off method and the allowance method.įigure 9.2 Bad Debt Expenses. When future collection of receivables cannot be reasonably assumed, recognizing this potential nonpayment is required. Bad debt negatively affects accounts receivable (see Figure 9.2). Fundamentals of Bad Debt Expenses and Allowances for Doubtful Accountsīad debts are uncollectible amounts from customer accounts. What happens when a loan that was supposed to be paid is not paid? How does this affect the financial statements for the bank? The bank may need to consider ways to recognize this bad debt. The understanding is that the couple will make payments each month toward the principal borrowed, plus interest. A bank lends money to a couple purchasing a home (mortgage). You continue to request the money each month, but the friend has yet to repay the debt. At the end of two months, your friend has not repaid the money. You lend a friend $500 with the agreement that you will be repaid in two months.
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