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 the 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 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 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 grants credits to its customers. Credit limits entice your customers to make a purchase. But every time a company grants a loan to a client, there is also the risk that the client will not return the money. To eliminate the risk, the company establishes some guidelines and policies to grant credit to its client. They carry out 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 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 remedies to try to collect your money, but these often fail and are also costly. This bad debt receivable is a loss in revenue recognized by 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 of recording bad debt expense. 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 gone to great lengths to collect 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’s a simple method, but it’s only acceptable in cases where the business has no 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 bad debts 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 preferable method of recording bad debt expense. This method is in accordance with 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 as 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 provision for uncollectible accounts communicates to your financial user that the accounts receivable portion is expected to be uncollectible. With the allocation 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 years’ 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 debt based on accounts receivable, a business can estimate the aging schedule provision or a single calculation based on total accounts receivable. When using the estimate based on accounts receivable, the journal entry for bad debt expense should consider the current balance in the reserve account. The entry amount is the amount needed to bring the reserve account balance to the desired ending balance amount.