The matching principle is the basis for accrued accounting and revenue recognition. According to the principle, all expenses incurred to generate the revenue must be deducted from the income earned during the same period. This principle allows better evaluation of actual profitability and performance and reduces the discrepancy between when costs are incurred and when revenue is recognized. On receivables that include expense reimbursement in the same year in which associated sales revenue is recognized, an application of a matching principle is applied.
Receivables represent the amount owed by customers for money, service or purchase of goods on credit. In the balance sheet, they are classified as current or non-current assets based on expectations of how long it will take to collect. The majority of receivables are accounts receivable arising from the sale of products or services to customers.
To help increase their sales revenue, the company extends credit to its customers. Credit limits entice its customers to make a purchase. But every time a company gives credit to a customer, there is also a risk that the customer will not repay them. To eliminate the risk, the company establishes some guidelines and policies to extend credit to its customer. They conduct a credit check to assess the customer’s credit rating. They set up collection policies to ensure they received the payment on time and reduce the risk of non-payment. Unfortunately, there are still sales on account that may not be collected. Either the customer breaks down, is not happy with the service provided, or simply simply refuses to pay them back. The company has legal application to try to collect their money, but they often fail and also costly. This unavailable receivable receivable is a loss in revenue recognized by recording bad debt costs. As a result, it has become necessary to establish an accounting process for measuring and reporting these uncollectible accounts.
There are two methods for recording bad debt expenses. The first method is “Direct Depreciation Method” and the second is “Addition Method”.
Direct depreciation method is a very weak method and it does not apply the matching principle of recording expenditure and revenue during the same period. This method only records bad debt expenses when a company has exerted all its efforts to collect the money owed and eventually declares them as uncollectible. It has no impact on income because it simply reduces receivables to 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 bumps during the year or bad claims are immaterial. For accounting purposes, a product is considered to be significant if it is large enough to influence the assessment of its financial users. With the direct amortization method, several accounting periods have already passed before it is finally determined to be independent and amortized. Revenue from credit revenue is recognized for a period, but the cost of uncontrollable accounts related to the sale is only recognized in the next accounting period. This results in a discrepant relationship between income and expenditure.
The supplementary method is a preferred method for recording bad debt expenses. This method complies with the generally accepted accounting principles. Receivables are recognized in the financial statements at net realizable value. Net realizable value is equal to the gross amount of receivables minus an estimate of receivables that cannot be collected. This is often called reimbursement for bad debt. This is considered a contract capital in the balance sheet. This contract capital account has a normal credit balance rather than debit amounts because it is a deduction for receivables. Additions for bad debt accounts inform the financial user that the portion of the receivables is expected to be uncollectible. Under the receipt method, you can estimate bad claims based on each period’s credit turnover or based on accounts receivable.
Estimating bad debt as a percentage of sales is consistent with the matching concept because bad debt expenses are recorded in the same period as the related income. It is calculated by specifying a fixed percentage of the debt provision from period to period to the bad debt account in the income statement. Previous years’ trends or patterns in credit turnover and related bad debt provide a basis for a reasonable estimate or projection of impairment charges for the current year.
When estimating bad debt based on receivables, a company can estimate the quota from the aging plan or a single calculation of the total receivable. When estimates based on receivables are used, the journal entry for bad debt expenses must consider the current balance in the allowance account. The amount of the item is the amount needed to bring the balance of the allowance account to the desired final amount.