The matching principle is the basis for accrual (or accrual) accounting and revenue recognition. According to the principle, all expenses incurred in the generation of income should be deducted from the income obtained in the same period. This principle allows for a better assessment of actual profitability and performance and reduces the mismatch between when cost is incurred and when revenue is recognized. In accounts receivable, the provision for bad debt expenses in the same year in which the related sales income is recognized is an application of the matching principle.
Accounts receivable represent the amount owed by customers for money, service or purchase of merchandise on credit. On the balance sheet, they are classified as current or non-current assets based on expectations of the time 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 credits to its customers. Credit limits entice your customers to make a purchase. But whenever a company extends a credit to a client, there is also the risk that the client will not return the money. In order to eliminate the risk, the company establishes some guidelines and policies to grant credit to its client. They conduct a credit investigation to assess the customer’s credit worthiness. They established a collection policy to ensure they received payment on time and reduce the risk of default. Unfortunately, there are still sales on account that may not be charged. Either the customer goes broke, is not satisfied with the service provided, or simply refuses to return the money. The company has legal recourse to try to collect your money, but those often fail and are costly too. This uncollectible account receivable is a loss of income recognized when recording the 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 write-off method is a very weak method and does not apply the principle of comparison 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 ultimately declares it uncollectible. It has no effect on income 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 the precise means to estimate the value of the defective teeth during the year or the 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 already passed before it is finally determined to be uncollectible and written off. Income from credit sales is recognized in one period, but the cost of doubtful accounts that are related to those sales are not recognized until the next accounting period. This results in an income and expense mismatch.
The allocation method is a preferable method for recording bad debt expenses. This method is in accordance with generally accepted accounting principles. Accounts receivable are recorded in the financial statement at their net realizable value. The net realizable value is equal to the gross amount of the accounts receivable less an estimate of the accounts receivable uncollectible. This is often called a bad debt allowance. This is considered a contractive account on the balance sheet. This contra asset account has a normal credit balance instead of a debit balance because it is a deduction from accounts receivable. The provision for bad debts communicates to your financial user that the part of the accounts receivable is expected to be bad debts. With the allocation method, you can estimate bad debts based on credit sales for each period or based on accounts receivable.
The estimation of bad debts as a percentage of sales is consistent with the concept of coincidence because the bad debt expense is recorded in the same period as the associated income. It is calculated by providing a fixed percentage of the period-to-period debt provision to the bad debt expense account in the income statement. Past-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.
When estimating bad debts based on accounts receivable, a business can estimate the aging calendar provision or a one-time calculation of total accounts receivable. When using the estimate based on accounts receivable, the journal entry for bad debt expense must consider the current balance in the reserve account. The amount of the entry is the amount that is needed to bring the balance in the allocation account to the desired ending balance.