The matching principle is the basis of accrual accounting and revenue recognition. According to the principle, all expenses incurred to generate the income must be deducted from the income earned in the same period. This principle allows for a better assessment of actual profitability and performance and reduces the mismatch between the time the cost is incurred and the time revenue is recognised. In accounts receivable, the provision for bad debt expense in the same year that the related sales revenue is recognized is an application of the matching principle.
Accounts receivable represents the amount owed by customers for money, service, or merchandise purchased on credit. On the balance sheet, they are classified as current or non-current assets based on expectations of how long it will take to collect. Most accounts receivable are trade accounts receivable, arising from the sale of products or services to customers.
To help increase its sales revenue, the company extends credit to its customers. Credit limits entice your customers to make a purchase. But every time a company grants a customer a loan, there is also a risk that the customer will not pay the money back. To eliminate the risk, the company establishes some guidelines and policies for granting credit to its customer. They conduct a credit investigation to assess the customer’s creditworthiness. They established a collection policy to ensure they received payment on time and reduce the risk of non-payment. Unfortunately, there are still sales on account that cannot be collected. Either the client goes bankrupt, is not satisfied with the service provided, or simply refuses to return the money. The company has legal recourses to try to collect your money, but they often fail and are also expensive. This bad debt receivable is a loss in income recognized when recording bad debt expense. As a result, it is necessary to establish an accounting process to measure and report these uncollectible accounts.
There are two methods for recording bad debt expenses. The first method is the “Direct Cancellation Method” and the second is the “Allocation Method”.
The Direct Penalty Method is a very weak method and does not apply the correspondence principle of recording expenses and income in the same period. This method records bad debt expense only when a business has made every effort to collect the money owed and finally declares it bad. It has no effect on results because you are simply reducing accounts receivable to their net realizable value.
It is a simple method, but it is only acceptable in cases where the company does not have an accurate means of estimating the value of bad dents during the year or bad debts are irrelevant. In accounting, an item is considered material if it is large enough to affect the judgment of its financial users. With the direct write-off method, several accounting periods have passed before it is finally determined to be uncollectible and written off. Revenue from credit sales is recognized in one period, but the cost of uncollectible accounts related to those sales is not recognized until the next accounting period. This results in a mismatch of income and expenses.
The allocation method is a preferred method of recording bad debt expenses. This method is in accordance with the Generally Accepted Accounting Principles. Accounts receivable are reported in the financial statement at their net realizable value. Net realizable value is equal to the gross amount of accounts receivable less an estimate of uncollectible accounts receivable. This is often called a bad debt allowance. This is considered a contra asset account on the balance sheet. This contra asset account has a normal credit balance instead of a debit balance because it is a deduction to accounts receivable. The allowance for uncollectible accounts communicates to your financial user that the accounts receivable portion is expected to be uncollectible. With the allowance method, you can estimate bad debts based on each period’s credit sales or accounts receivable.
Estimating bad debt as a percentage of sales is consistent with the matching concept because bad debt expense is recorded in the same period as the associated revenue. It is calculated by providing a fixed percentage of debt provision from period to period to the bad debt expense account on the income statement. Prior year trends or patterns in credit sales and related bad debts provide a basis for a reasonable estimate or projection of bad debt expense for the current year.
By estimating bad debt based on accounts receivable, a business can estimate the aging schedule allowance or a one-time calculation based on total accounts receivable. When using the accounts receivable-based estimate, the journal entry for bad debt expense should consider the current balance in the reserve account. The input amount is the amount needed to bring the reserve account balance to the desired ending balance amount.