Unlike cash basis accounting that recognizes revenue when cash is received and expense is recognized when cash is paid, accrual accounting follows rules where revenue is recognized when earned, and expenses are recognized when they are incurred. This form of accounting conforms to generally accepted accounting principles (GAAP) and because accrual basis accounting is simply the posting of income and expenses as they occur, rather than deferring the postings until a later date, this form of accounting is the favored method by most businesses. More accurate financial evaluation of actual profitability and performance is achieved by eliminating accounting entry timing disparity. A key element of accrual accounting is the matching principle, which along with revenue recognition rules is the foundation to accrual based accounting.
The GAAP matching principle allows companies to recognize revenue, and recognition of the related expenses, as they occur. This results in a more accurate analysis of current financial records at any point during the accounting period. A representative way to illustrate this process is by looking at uncollectable accounts receivable. When a sale is recognized to a credit worthy customer the transactional entry is a debit to accounts receivable on the balance sheet, and a debit to sales on the income statement. A typical entry would be:
Debit – Accounts Receivable $xx.xx
Credit – Sales $xx.xx
It is assumed that the accounts receivable entry represents a liquid asset in that it will be converted to cash in a reasonably quick amount of time, say 30 days. When the debt is collected cash is debited (increased) and accounts receivable is credited (reduced). The effect of the transaction would look like this:
Debit – Cash $xx.xx
Credit – Accounts Receivable $xx.xx
This is an over-simplified example; a more realistic scenario would have trade receivables consisting of over 4,000 customers owing the company $392 million dollars and consisting of 52,000 individual collectable transactions. Credit managers oversee this asset and monitor the credit worthiness of customers in order to mitigate the risks involved with selling marginal customers on open terms. Because a certain degree of risk is necessary in order to maximize sales it is known that a certain percentage of the receivables may not be collected. In order to properly convey the portion of the trade receivables that may not be collected an allowance for bad debt accounts is established in accordance with the matching principle.
To conform to Generally Accepted Accounting Principles (GAAP), accounts receivable is presented on the balances sheet as a net receivable value. This net value is calculated by subtracting an estimated allowance for doubtful collections from the gross receivable value. In essence this entry reduces gross accounts receivable to an amount more accurately depicting the anticipated amount to be collected. This valuation adjustment is known as the allowance for bad debts and is represented on the asset side of the balance sheet as a negative entry and a negative entry on the income statement as an expense. The effect of the transaction would look like this:
- Debit – Bad Debt Expense $xx.xx
Credit – Allowance for bad debts $xx.xx
The allowance for bad debt accounts is called a contra-asset account. A contra asset account is a credit balance that offsets a corresponding debit balance. For instance if gross accounts receivable is $312,000 and the allowance for bad debts is determined to be $47,000 the net accounts receivable is $265,000 ($312,000 – $47,000 = $265,000). This is represented on the balance sheet as:
Accounts Receivable…………………………….$312,000
Less: Allowance for bad debts………..…..……..-$47,000
Net Accounts Receivable………..……… ……..$265,000
Matching the allowance for doubtful accounts with the gross trade receivable balance derives at a more rational appraisal of this liquid asset. When companies under value their exposure to uncollectable debt they overstate liquidity and over value net worth. With the continued weakness of worldwide economies proper evaluation of the receivable asset becomes more important. It is clear to see that tighter credit, diminishing demand and a continued weak property market are pushing an increasing number of companies and individuals into insolvency. Banks use a term called “loan loss reserve†to represent the dollar value they place on potential losses from customer loans. In August 2009 the SEC issued a letter to all bank CFOs urging them to reassess the value of their loan loss reserves. In fact, setting loan loss reserves has been a sore subject between the banks and the SEC for several years. As we all found out, several major banks were found to have inadequate reserves to cover their loan defaults and took many investors for a shocking surprise.