Christian Debt Recovery

Bad Debt Expense Accounting Principle

December 30th, 2008 |

Author: Gavin

Accounting Basics: The Matching Principle as It Relates to Accounts Receivable and Uncollectible Accounts

The matching principle and its implementation with regard to accounts receivable, including accounts that are not collectible, help to ensure the accurate reporting of net income. Understanding these concepts not only increases comprehension of balance sheets and income statements, but also illuminates key aspects of the recent financial crisis.

The matching principle

Accrual accounting is based on the concept that revenue and expenses are captured as they happen, whether or not payment is received or dispersed at that time. The matching principle mandates that all of the expenses required to obtain income, or revenue, be subtracted from that revenue at the same time that the revenue is reported.

The basic formula is revenue minus expenses equals net income. This information is shown on an income statement. For example, a car dealer sells a car for $20,000. The $20,000 is recorded as revenue. If the car dealer paid $15,000 for the car and had additional expenses of $1,000, a total of $16,000 is subtracted from the $20,000 during the same period that the revenue is recorded. The result is a net income of $4,000. This is recorded as follows:

Credit revenue for $20,000, and debit expenses for $16,000.

Recording accounts receivable

The total amount of the sale, minus any cash received as a down payment, is entered under accounts receivable. This information is recorded as assets on the balance sheet. Thus, if a down payment of $3,000 is made on the $20,000 car purchase described above, the following is recorded:

Debit cash in the amount of $3,000, and debit accounts receivable for $17,000.

As the car’s owner makes $500 payments each month, cash will increase by $500 and accounts receivable will decrease by $500. These transactions will not alter net income, which has already been determined at the point of sale.

Allowing for bad debt

Problems arise when customers do not fully pay their debts. The matching concept dictates that bad debt expense, also referred to as uncollectible accounts expense, be recorded in the same period as revenue, even though the actual default is in a different period, months or years later. To do this, companies estimate the amount of bad debt likely to occur in a given period and record this as an allowance for bad debt, decreasing accounts receivable and increasing expenses. If the car dealer estimates bad debt will be $20,000, it is recorded as follows:

Debit bad debt expense $20,000, and credit allowance for bad debt $20,000.

The allowance for bad debt is considered a contra asset. This means that it is subtracted from assets on the balance sheet. While it is normal for assets to be recorded as debits, in this instance, the bad debt allowance is posted as a credit.

As actual defaults occur, the real amount of bad debt will be written off. When this happens, the precise amount of bad debt is subtracted from accounts receivable, and the same amount added to the allowance for bad debts. This is recorded on the balance sheet. It does not affect the income statement, since it has already been captured under the bad debt expense. Should one of the car dealer’s customers default on $3,000, the transaction is recorded as follows:

Debit allowance for bad debt $3,000, and credit accounts receivable $3,000.

The impact of poor estimates

Whether calculated by taking a percentage of total accounts or by taking percentages that vary based on the amount of time accounts have been past due, the bad debt allowance is ultimately an educated estimate. When the bad debt allowance is too high or too low, the reported net income is inaccurate. Thus a company can appear to be healthier than it is or be undervalued.

The importance of this concept has been illustrated over the past few years. Allowing for bad debt is an integral part of the banking industry, in which the loans themselves are a significant source of revenue, in the form of interest. The principles behind the allowance for bad debts can be transferred to loan loss reserves in the banking industry. A loan loss reserve is the amount set aside to cover anticipated losses due to default. Loan loss reserves that are too small not only misrepresent income, but more seriously, can jeopardize the viability of a bank, contributing to bank failures and bail outs of banks “too big to fail.” Conversely, the slow recovery may be in part related to banks keeping too much in their loan loss reserve—or of banks raising the standards on loans so that the risk of default is lower as is the amount required to offset it — thereby restricting the availability of loans.

About the Author

Susan Casey is a supervisor for a major pharmaceutical company and an MBA student at West Chester University.