Learn about percentage-of-sales approach and percentage-of-receivables approach in calculating allowance for doubtful accounts and bad debt expense.

1. Matching revenues with expenses (matching principle)

The matching principle in accounting states that revenues should be matched with expenses incurred in generating those revenues. In other words, expenses incurred to create revenues should be included in the income statement in the same reporting period as the revenues.

When a company sells products or provides services on account (i.e., credit sales), almost always there is a risk that some outstanding amounts due from customers will not be collected. Customers may become bankrupt or refuse to pay for a variety of other reasons. Such amounts are called uncollectible and represent an expense to the company. The expense is called bad debt expense. However, there is usually a time lag between the period when a customer purchases a product or service and the period when it becomes known that the balance due from the customer will not be collectable. Therefore, a company needs to estimate how much of its accounts receivable will be uncollectable. Such uncollectible amounts should be recorded in the period of related sales to satisfy the matching principle. In particular, the estimated bad debts (i.e., amounts that the company thinks will be uncollectible) are recorded as an expense in the same period as the sales revenues that created the potentially uncollectable amounts due from customers.

The amounts deemed by a company to be uncollectible are recorded in a contra-asset account called allowance for doubtful accounts. This account is subtracted from gross accounts receivable to arrive at net realizable value of accounts receivable on the balance sheet. There may be several methods to estimate how much of accounts receivable will eventually be uncollectible. Two of such methods are the percentage-of-sales approach and the percentage-of-receivables approach. Applying such approaches falls within the allowance method of accounting for bad debts.

Note that there is also a direct write-off method of accounting for bad debts. Under this method a bad debt is recognized as an expense when it becomes known that the amount due from a customer is uncollectable. Unless amounts involved are immaterial, using the direct write-off method is not in accordance with US GAAP because the matching principle is not satisfied in most cases.

After we have covered some basics about the allowance method of accounting for bad debts, let’s review in more detail the percentage-of-sales and percentage-of-receivables approaches.

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