 Hello and welcome to this session in which we would look at the allowance method for in-collectables. Why do we have to study the allowance method of in-collectable when it comes to account receivable? Well, simply put, we don't live in a perfect word. If we live in a perfect word, simply put, when we sell something on account to Ryan for a hundred dollars, we debit account receivable Ryan, credit sales revenue. Thirty days later, Ryan will pay his bill, we'll debit cash, credit the receivable. So simply put, the receivable is gone, what's left is we make a sale for one hundred dollars, we receive the cash, and we record the revenue. And this will be the end of the chapter four chapter that deals with account receivable. Obviously, we don't live in this word. What happens sometime is some customers such as Ryan or other customers, they don't pay their bill. Well, as a result, we have to account for the allowance. We have to account for the in-collectable accounts. Well, how do we do so? There are two methods to be used. We have the direct write-off method, which is not a gap method. And we looked at this in the prior session and we explain it. So this is done. And we have the allowance method. Allowance method is a gap method. The allowance method is a little bit more involved. The allowance method will have a two-step approach. We'll look at them later. The allowance method will have the income statement approach, where we can use the income statement. The income statement is only one step, actually. And we have the receivable approach, also called the balance sheet approach, which is a two-step process. Under the balance sheet approach, we could use a percent of receivable, or we can use the aging process. So we have A and B under the receivable approach. And this is what we're going to be focusing on in this session. The receivable approach rather than the, I'm sorry, not the receivable, the allowance rather than the direct write-off method. Because in the prior session, we covered the direct write-off method. Now whether you are an accounting student or a CPA candidate, I strongly suggest you take a look at my website, farhatlectures.com. This topic is extremely important and covered on the CPA exam. I don't replace your CPA review course. I'm a useful addition. I can add 10 to 15 points to your exam by helping you understand the material better. Your risk is one month of subscription. Your potential gain is passing the exam. If not for anything, take a look at my website to find out how well or not well your university did a wing on the CPA exam. My course catalog include not only intermediate accounting, auditing, a cost accounting, advanced taxation, governmental, so on and so forth. My supplemental courses are aligned to go with your Wiley, Roger, Gleam, or any other CPA review course you are taking, at least the major ones. And I have all the previously released AI CPA exam questions, approximately 1400 to 1500 with detailed solution. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation. Like this recording, share it with other, connect with me on Instagram, Facebook, Twitter, and Reddit. So we're going to be looking at the two methods, specifically of the allowance, the income approach, and the receivable approach. But before we do that, it's very important to remember why we don't use the direct write off method and we use the allowance method. And this is what we looked at in the prior session. The direct write off is used for tax purposes. It's not gap and the reason it's not gap for two reasons. One, it does not state receivable at an RV net realizable value and it violates the matching principle. Now the allowance method is a gap method. And this is why we need to learn it. It estimate in collectible at the end of the period. So at the end of every accounting period, what we do is we have to make an adjustment. And that adjustment will help us estimate, notice the word estimate, how much we are going to have in collectible, even before it happens, which it does what? It matches the revenues with the expenses. And also when we estimate, when we have the estimated of in collectible, that's going to give us the receivable minus the in collectibles, which is the amount that we cannot collect. And as a result, we are going to receive, we are going to report, not receive an RV, which is the net realizable value. Therefore, we would report the receivable at net realizable value. In other words, how much we can collect as a result, the allowance method is the gap method, not the direct write off method. So now the key is to know how to use this method, the allowance method. So it complies the most important thing. It complies with the matching principle. And the best way to see this is to work an actual example, starting with the easy approach, the income statement approach, the allowance income statement. For one thing, it's a one step process. Let's work an example to show you how the income statement approach works. Let's assume we are giving this data. We have a count receivable 150, allowance for doubtful account 40,000, sales revenue on credit 1.5 million, sales returns and allowances 100,000. Now you might be asked to prepare the journal entry for bed debt expense, assuming the company use sales 0.5% of sales as their base. So this is the sales method. How does the sales method work? We'll take sales on account, which is sales on credit, multiplied by the rate 0.005, because it says 0.5%. And that's going to give us 7,500. From here, we are going to debit bed debt expense, credit allowance for doubtful account. So here's what we did. And this happens usually at the end of the period as an adjustment. So at the end of the year, we will debit bed debt expense, credit allowance for doubtful account allowance. We're going to talk about allowance shortly, a little bit more. It's a contra asset, specifically contra asset to receivable. So we are going to reduce receivable, but we don't know which account specifically. So we have 150,000 of receivable minus 7,500, but we don't know which 7,500. Therefore, for now, we're going to do, we're going to record this in an account called allowance. Therefore, 150 minus 1,000, 7,500 equal 142,100, 142,500. My math is pretty rusty. So this is the NRV. So this is how we would report the NRV. So notice what we did. I'm going to point this out. We ignored, we ignored this allowance balance here. Notice we have an allowance of 40,000. Under the income statement approach, our focus is bed debt expense. Therefore, we focus on bed debt expense and the allowance is a byproduct of our computation. So it's very simple. This is the income statement approach. Take sales on credit times a percentage, debit bed debt expense, credit allowance. Now we're going to look at another method called the balance sheet method. To explain the balance sheet method, because it's a little bit involved, I'm going to explain it a little bit more in details before I show you the summary of it. Okay, let's take a look at an example again to illustrate the balance sheet method. Adam has credit sales of 2 million in its first year of operation. It's important to assume it's a first year of operation and you will see why later. Of this amount, 200,000 remain in collectibles. Well, what does that mean? It means this company has an account receivable if it's not collectible of 200,000. Management in conjunction with the collection department estimate that 10,000 will be in collectible. So 10,000 of this amount will be in collectible. Okay, so simply put 10,000 is in collectible. This should be our target balance. So what we do, we say, okay, we have an allowance. We have to record that bed debt expense and the allowance and the allowance, we assume it's zero because it's first year of operation. Therefore, we need to have 10,000. That's easy. We're going to debit bed debt expense credit allowance. So notice why I started with this example this way is to emphasize the point that I don't have anything from the prior year. Now I'm going to change this on the next slide, but it's very important to understand that if we are using account receivable as a base, which we did, we said of this amount, 10,000 of this amount is in collectible, which is this information could be given to us as 5% is in collectible. Same thing, 5% of 200,000 is 10,000. We debit bed debt expense credit receivable. This is how we show the information on the balance sheet. We would still show account receivable at 200,000. Less allowance of 10,000 will give us 190. And this is called NRV or net realizable value. We have to estimate the receivable at net realizable value. This is how it's valued on the balance sheet. Now remember in the allowance, we have 10,000 now to start the year. So this is the end of 20x6 at x5. So notice this is the end of 20x5. Now we're going to go to year 20x6. And when we started the year, remember we have an allowance of $10,000, which is a contra asset. Here comes 20x6. And on March 2, head of the collection in conjunction with management department decided to write off Ryan's account of $1,000 after repeated attempts of collecting the account. So we don't think Ryan's going to pay his balance. Ryan owes us $1,000. If you remember we had $200,000 in total. Now we know one of them, Ryan owes us $1,000 and Ryan is not going to pay his bill. At this point, we are going to write off Ryan's account. When we write off an account under the allowance method, there's no expense. What does that mean? It means what we debit is we debit the allowance. Why not? Because the expense took place. Notice where the expense took place. The expense took place at the end of the year. The expense took place when we made the adjustment at the end of 20x5. So on 20x6, when we write off the account, there's no expense because the expense took place earlier. Therefore, our allowance went down by $1,000. So our receivable went down by $1,000 and our allowance went down by $1,000. So notice what I need to show you. Our receivable was $200,000 minus $10,000. It was $190,000. After we wrote off the account, our receivable goes down by $10,000 to $190,000 and our allowance went down by $1,000 to $9,000. So notice it doesn't change an RV. So after we write off an account, it doesn't change an RV because there's no change to expenses. So notice now, if I ask what is the balance in the allowance, you would say the balance is $9,000. So when we write off an account, we debit allowance and we remove Ryan's account. Ryan's, that's it. He's not going to pay us. Fast forward till September 5th. Nothing happened between March till September 5th. On September 5th, again, management and the collection department agreed that King's account is in-collectible and King's owe us $5,000. Well, we have to write off King's account debit allowance for $5,000 credit the account receivable for King $5,000. Again, we're reducing our allowance by $5,000. Bad news, but it's still good. We're still good because we estimate the 10. So far we wrote off six. On November 15th, Ryan sent a check, sent a check of $1,000 to pay off his balance. Excellent. So if remember, we wrote off Ryan's account. If Ryan sends money to pay off his balance, we're going to have to reinstate the account first. So first, we reverse it. We reinstate the account by reversing the entry. We debit the receivable for Ryan, credit the allowance, $1,000 and $1,000. So notice what we did. We add back $1,000 to the allowance and then we accepted the cash. We debit the cash, credit the account receivable and most likely we're not going to sell Ryan anymore on credit. Okay. So this is what happened. At the end of the period, we're going to compute our ending balance and the allowance and our ending balance is $5,000. So we started with $10,000. We estimated $10,000 to be incollectible. First, we wrote off six. Then Ryan sent a check of $1,000. We end up with $5,000. This is a credit balance. What does that mean? Simply put, we estimated $10,000. We only wrote off in total $5,000 and we still have $5,000 remaining in the credit balance. A remaining credit balance means we overestimated the allowance by $5,000. So this year, we overestimated. It's not a big deal. We overestimated. You don't want to overestimate by too much. You don't want to underestimate by too much. But basically, we overestimated by double because we estimated $10,000. We only wrote off $5,000, which is good. We were very conservative. It didn't really realize all the customers were paying us, except two customers that we really gave up on. So this is what it means. So write this down. If the balance and the allowance is credit, it means we overestimated. This is important. Let's go now to year two, at the end of year 2006. During 2006, we had credit sales of whatever amount. Of this amount, $350 remain incollectible. It doesn't matter. We had credit sales of $5 million. It doesn't matter how much credit sales. What matters is we still have $350. Management and conjunction with collection estimates that $17,000. $17,000 of $350 will be incollectible. So now we have $17,000. Now we need to estimate that expense and allowance for doubtful account. Remember, we are dealing with December 31st, 2020, X6. Now the balance from the prior year was $5,000. Now we need to have a balance. Notice the sentiment carefully. We need to have a balance of $17,000. That's what we need to have. Well, if we need to have a balance of $17,000, all what we need is only $12,000. Therefore, we debit bet that expense $12,000. Credit allowance $12,000. We need $17,000. However, from the prior year, we had a balance of $5,000. We already have a balance of $5,000. We need $17,000. All what we need is $12,000. Therefore, we debit bet that expense $12,000. Credit allowance $12,000. Let's go through 2020 X7. During 2020 X7 on October 10th, head of the collection department in conjunction with management, write off my account, Farnhats account of $20,000 after repeated attempt of collecting the account. Again, I always pay my bills. This is just for the sake of illustration. So now we have $20,000. We have to write off. We're going to debit allowance for doubtful account $20,000. We're going to credit the account receivable for Farnhats, remove Farnhats account receivable for $20,000. So let's see what's going to happen to the balance now. Further, we're going to debit the balance $20,000. Now the balance is a $3,000 debit. And this is what happened to our allowance account. Now the allowance account is a debit of $3,000. What does that mean? It means we underestimated. We started the year thinking we're only going to write off $17,000. We end up writing off one account, which is Farnhats, blow it, blow it for us. Okay, we did not pay his account and we are down $3,000. A debit balance means we underestimated, although you cannot see the word underestimate, we underestimated by $3,000. That's exactly what happened. We underestimated. So that's why we need to know the difference whether we have a debit balance or a credit balance from the prior year. The prior year we had $5,000 credit balance. This year we end up with $3,000. So when we make our adjustment for the following year, we have to take that $3,000 underestimate into account. Now the best way to illustrate this is to actually work an example. Let's take a look at this example. And this is called the two-step approach. We have a count receivable of half a million, allowance, credit balance of $40,000, sales revenue $1.5 million, sales returns and allowance is $100,000. I'm going to ask you to prepare the journal entry, assuming the company estimate that expense at 10% of receivable. Well, it's a two-step approach. Here's the two-step approach. First, you compute your target balance. Your target balance is your receivable times the percentage. So your target balance in the allowance should be $50,000. Well, guess what? It should be $50,000. That's fine. But I already have, let me change colors here, I already have in my balance and the allowance, I already have $40,000. So if I need to have $50,000, all what I need is only $10,000. All what I need is $10,000. Therefore, I'd have it bet that expense $10,000, credit the allowance $10,000. So this is the two-step approach. First, you find your target balance, then you find your entry. Well, how do you find your entry? After you find your balance, this is the first step. The entry is, if you have a credit balance, you'll take the difference between the prior balance and the target. So if it's a credit balance, you'll take the difference between the two. The difference between the two is $10,000 and that's your entry. We do take into account the prior balance. Remember, this is the account receivable approach. We do take into account the prior year balance. The focus is on the allowance account. So this is why it's called the balance sheet approach. We're focusing on the allowance. Allowance is a balance sheet account. It's a contra asset. Now, we can switch this example and show you what happened if the balance rather than a credit was a debit. So let me show you what happened if the balance was a debit. So I'm going to erase everything and change the scenario. So I'm going to erase all and say rather than credit balance, we started the year with a $40,000 debit. Well, here's the allowance now. From the prior year, we had a debit balance of $40,000. Now we need to have a credit balance of $50,000. This is the target, right? The target is $50,000. Then what do we need to do? Well, if it's a debit balance, if it's a debit balance, the entry is the sum between the target balance and the existing balance. The target balance is $50,000. The existing balance is $40,000. Therefore, we debit that expense $90,000, credit allowance $90,000. So basically, we're going to credit the allowance $90,000, started with $40,000 debit, $90,000 credit will give you a target balance of what we need of $50,000. Again, whether it's a debit or a credit, you need to take into account the prior year balance, the prior year balance, and you have to take it properly. If it's a debit, you will take the target plus the existing balance. If it's a credit, you will take the target minus the existing balance. Okay? Big difference between the two, big difference between the two. Make sure you know the two for the exam. Now, what we did here is we took the whole account receivable and we multiply it by a percentage. So we took half a million times 10%. Well, you don't have to do that. Sometimes what companies do, and most companies what they do, they age the receivable. So rather than taking half a million times 10%, what they do is they take the receivable by customer and they age them. What do I mean by aging? It will show you how long or how overdue each customer separately. For example, this is our total balance of half a million and this is composed of 1, 2, 3, 4, 5 customers. Eastern product owes us 67, trust limited to 40, so on and so forth, total of half a million. Now we're going to look at Eastern product. 14,000 of his balance is under 30 days and 53,000 is 30 to 60 days outstanding. Trust limited, 240, 75 is current, 10,000, 30 to 60, 15,000, 61 to 90 and 140,000. We'll have to be careful with trust. They're not paying their bell. Robin Tito, 111, everything is current under 30 days. Surface Pro, 34,000, 10,000 is current and 24,000 is overdue and limited. We should stop selling anything to limited because the balance, the existing balance is 48,000 overdue. Now, rather than taking 1% times half a million, what we do now is we're going to age each group. We have 210 current, 87,000, 30 to 60 days, 15,000, 61 to 90 days, so on and so forth. Now what we do is we project percentages for each group separately. Starting with the account balance below 30 days, we're going to assume 1% of this amount will be in collectible. 4% of this amount of the 87,000 will be in collectible, 10% of the 15,000, 20% of the 140 and 40% of the 48. And notice, as the account receivable gets older, the percentage gets higher. And the logic behind this is the longer it takes you to collect the balance, the higher the probability you will not receive it. Therefore, you would project a larger percentage of the in collectible. Now we compute them 210,000 times 1%, 87,000 times 4%, 15 times 10%, 140 times 40,000 times 20%, 48,000 times 40%. Overall, our target balance now is 54,280. Well, we already have an allowance, we already have in the allowance 40,000. And now we need the target balance of 54,280. What are we missing? First of all, it's a credit balance. Take the difference between the two. The difference between the two is 14,280. Therefore, the entry is for to bet that expense, for allowance and bet that expense 14,280. So this is the, again, this is receivable, but it's a different method. Rather than projecting 1%, you age the receivable. This is considered more accurate, because when you project 1%, you are treating all the outstanding receivable the same. Most companies use the aging, the aging of receivable, because it truly tells you, it gives you a better picture. Now, to summarize the allowance versus the allowance method, income versus the balance sheet. The income statement is one step approach, you ignore any prior balance. Simply put, you bet that expense is computed by taking sales on credit times that percentage given and done. The balance sheet is a two-step approach. You consider the prior year balance and you start by taking the account receivable times the percentage. And that's going to give you the allowance target. Now, from the target, you would look at your prior balance. If the prior balance is credit, you will take the difference between those two, the target and the credit balance. And that's your bet that expense. If the prior balance is debit, what you do is you do the opposite. You will take the target balance and you will sum the debit balance and the target. So make sure you know the difference and make sure you know what does a debit credit balance in the allowance mean. It means you overestimated. What does a debit balance mean? It means you underestimated from the prior year. Therefore, you will make the adjustment the following year. At the end of this recording, I'm going to remind you again, whether you are an accounting student or a CPA candidate, to take a look at my website, farhatlectures.com. I don't replace your CPA review course. I'm a useful addition to your education. I'm a backup alternative explanation. I can help you pass the CPA exam by helping you understand the material better. The CPA exam is a lifetime investment. Take it seriously. Good luck. Study hard. Accounting is worth it. And good luck.