Matching principle is the foundation of accrual accounting and revenue recognition. According to the principle all expenses incurred in generating the revenue must be deducted from the revenue earned in the same period. This principle allows better evaluation of actual profitability and performance and reduces mismatch between when cost is incurred and when revenue is recognized. In accounts receivable providing for bad debt expense in the same year in which related sale revenue is recognized is an application of matching principle.
Accounts receivable represents the amount due from customers for money, service or purchase of merchandise on credit. On the balance sheet, they are classified as current or noncurrent assets based on expectations of the length of time it will take to collect. Majority of receivables are trade receivables, which arises from the sale of products or services to customers.
To help increase their sales revenue, company extends credits to its customers. Credit limits entice its customers to make a purchase. But whenever a company extends a credit to a customer there's also a risk that the customer will not pay them back. In order to eliminate the risk company sets up some guidelines and policies for extending credit to its customer. They conduct credit investigation to assess the customer's credit worthiness. They set up collection policy to ensure that they received the payment on time and reduce the risk of nonpayment. Unfortunately, there are still sales on account that may not be collected. It's either the customer go broke, unhappy of the service provided, or just simply refuse to pay them back. Company does have legal recourse to try to collect their money but those often fail and costly too. This uncollectible accounts receivable is a loss in revenue recognized by recording bad debt expense. As a result, it is becoming necessary to establish an accounting process for measuring and reporting of these uncollectible accounts.
There are two methods for recording bad debt expense. The first method is the "Direct Write-off Method" and the second is the "Allowance Method".
The Direct Write-off Method is a very weak method and it does not apply the matching principle of recording the expenses and revenue in the same period. This method records bad debt expense only when a company has released all it effort in collecting the money owed and finally declares it as uncollectible. It has no effect on income because it is simply reducing the accounts receivable to its net realizable value.
It is a simple method but it is only acceptable in cases where the company has no accurate means of estimating the value of the bad dents during the year or bad debts are immaterial. In accounting, an item is deemed 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. Revenue from the credit sales are recognized in one period but the cost of uncollectible accounts that is related to those sales are not recognized until the next accounting period. This results to a mismatch of revenue and expenses.
The Allowance Method is a preferred method of recording bad debt expenses. This method is in conformity with the Generally Accepted Accounting Principles. Accounts receivable are reported in the financial statement at net realizable value. Net realizable value is equal to the gross amount of receivables minus an estimate of uncollectible accounts receivable. This is often called permission for bad debts. This is considered as a contra asset account in the balance sheet. This contra asset account has a normal credit balance instead of debit balance because it is a deduction to accounts receivable. The permission for bad debt accounts communicates to its financial user that the portion of the accounts receivable is expected to be uncollectible. Under the allowance method, you can estimate bad debts based on each period credit sales or based on accounts receivable.
Estimating bad debt as a percentage of sales is consistent with the matching concept because the 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 in 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 the bad debt expense for the current year.
In estimating bad debt based on receivables a company may estimate the allowance from aging schedule or a single calculation of based on the total accounts receivable. When using the estimate based on the receivables, the journal entry for bad debt expense must consider the current balance in the allowance account. The amount for the entry is the amount that is needed to bring the balance in the allowance account to the amount desired ending balance.