Direct write-off method. For tax purposes, companies must use the direct write-off method, under which bad debts are recognized only after the company is certain the debt will not be paid. Before determining that an account balance is uncollectible, a company generally makes several attempts to collect the debt from the customer. Recognizing the bad debt requires a journal entry that increases a bad debts expense account and decreases accounts receivable.
The Internal Revenue Service permits companies to take a tax deduction for bad debts only after specific uncollectible accounts have been identified. Unless a company's uncollectible accounts represent an insignificant percentage of their sales, however, they may not use the direct write-off method for financial reporting purposes. Since several months may pass between the time that a sale occurs and the time that a company realizes that a customer's account is uncollectible, the matching principle, which requires that revenues and related expenses be matched in the same accounting period, would often be violated if the direct write-off method were used. Therefore, most companies use the direct write-off method on their tax returns but use the allowance method on financial statements.
Allowance method. Under the allowance method, an adjustment is made at the end of each accounting period to estimate bad debts based on the business activity from that accounting period. Established companies rely on past experience to estimate unrealized bad debts, but new companies must rely on published industry averages until they have sufficient experience to make their own estimates.
The adjusting entry to estimate the expected value of bad debts does not reduce accounts receivable directly. Accounts receivable is a control account that must have the same balance as the combined balance of every individual account in the accounts receivable subsidiary ledger. Since the specific customer accounts that will become uncollectible are not yet known when the adjusting entry is made, a contra-asset account named allowance for bad debts, which is sometimes called allowance for doubtful accounts, is subtracted from accounts receivable to show the net realizable value of accounts receivable on the balance sheet.
Pls click on the link for illustrations of the journal entries and general ledger entries.