What is a Write Off Account Receivable?
A write-off is an expense item that has been expensed, as opposed to a normal expense which has not been incurred. A write-off arises due to the enterprise or its owner expensing a financial loss or expenditure for their business. The writing off of an expense is viewed positively by accountants and lenders because it reduces the book value of the company.
Accounts receivable is the amount owed to the company by the customers that have bought goods on credit i.e. the sale for the goods has been made but the company is yet to receive the payments at the end of the accounting period.
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What Effect Does a Write Off Have on Accounts Receivable?
Write off account receivables are important to accounting. They are simply useful in the following ways:
1. Decreases provision for bad debts and accounts receivable by comparable amounts
A write-off of accounts receivable will have a negative impact on the provision for bad debts, which is an expense that is adjusted each time a customer defaults on an obligation. The write-off will decrease the credit risk on the accounts receivable and reduce the estimated loss.
The reduction in accounts receivable will be comparable to the bad debt expense, which means that it will have no effect on net earnings. The decrease in net earnings is offset by a reduction in provision for bad debts, but net earnings are not affected since bad debt expense has been minimized.
2. Can be viewed as a tax loss
Both banks and investors often look at writing off accounts receivable as potential income tax loss that can be carried forward to reduce the taxable profits of the company or business. The write off is treated by accountants as a financial transaction in which a loss has been incurred on the accounts receivable.
3. May be viewed as a bad asset
A write-off of accounts receivable may not be considered a bad asset, but it is clearly an impairment on the customer’s financial right to collect payment. This affects the value of uncollectible receivables and results in no profits, since there is no cash flow from an uncollected debt.
What is the impact of a write off of accounts receivable on a firm’s net income?
A write off has a negative impact on the net income for the accounting department of a business or enterprise. These accounts are considered as a loss and may be passed off to the owner of the enterprise, who is deemed to be the tax liability. The majority of businesses that write off accounts receivable do not have other assets that can offset their losses, therefore they are not in contention for profits.
- Impact on Accounts Receivable
Accounts receivable is owed by customers to the bank. Accounts receivable are normally underwritten by banks and are financed to the business or enterprise. Accounts receivable financing gives businesses and enterprises the opportunity to extend credit to their customers.
The profitability of a business can be determined by looking at accounts receivable as a percentage of net worth. The primary obligation of both banks and accountants is to manage the accounts receivable, which is made up of trade credit, factoring and banking loans.
The Two Methods for Writing-off Bad Debts
1. Direct Write-off Method
The direct write off method is the recording of a bad debt expense upon the identification of an asset as loss. This recording of bad debt expense is in accordance with GAAP (generally accepted accounting principles).Using the direct-off method, the company will record the losses due to bad debts as they are incurred. The direct-off writing off method requires companies and enterprises to add back any provisions for bad debt that have been charged against earnings during that accounting period. This method is used when the asset is no longer able to be used for its intended purpose.
Example
Wayne made sales of $7,000 to Judy on credit in 2016. After so many attempts of trying to recover the money by Wayne in 2018, Judy filed for bankruptcy and was unable to pay back Wayne. Since Wayne could not collect the receivable from Judy, this $7,000 should be written off during 2018.
How is Wayne supposed to go about this bad debt expense?
Wayne should pass the following journal entry in his books to write off Judy from his accounts receivable:
Bad debt expense Dr 7,000
Accounts receivable Cr 7,000
$7,000 shall be reported as an operating expense in his income statement for the year ended 2018 and accounts receivable on his balance sheet shall be reduced by this amount.
2. Allowance Method
The allowance is used to reduce the value of the bad debts that are owed to the bank in an ethical way. This is done by deducting the allowance from net accounts receivable. The allowance will decrease as bad debts are written off, until it reaches zero and no further bad debts are expected in the future.
Example
At the beginning of 2014, Bidco Company had a credit balance of $150,000 in its allowance for doubtful accounts. Based on past experience, Bidco expects 2% of its credit sales to become uncollectible. During Year 2014, Omar wrote off $75,000 in uncollectible accounts and made credit sales of $2 million. What amount should Bidco report in its allowance for doubtful accounts at the end of Year 2014?
Explanation;
The ending balance in allowance for doubtful accounts is calculated by;
Beginning balance of $150,000 + amount for current year bad debt ($2,000,000 in credit sales x 2%) – $75K for accounts written off
$150,000 + ($2,000,000 in credit sales x 2%) – $75,000
$150,000 + $40,000 – $75,000
$190,000 – $75,000
= $115,000
taking the beginning balance of $150,000 + $40,000 for current year bad debt ($2,000,000 in credit sales x 2%) – $75K for accounts written off.
The write off of accounts receivable is an expense item that has been recorded as a credit loss, which means that it was expensed instead of incurred. The writing off of accounts receivable results in a loss in financials. A write-off is considered positive by accountants and lenders because it reduces the book value of the company. The two methods that can be used to reflect write-offs for bad debt expense are direct write-off method and allowance method.
Additional Resources
Above has been the Write Off Accounts Receivable guide. To advance your accounting career, read more about the other elements that populate financial statements:
