 In this presentation, we will be taking a look at the Allowance Method for Accounts Receivable focusing in on the calculation of the Allowance for Doubtful Accounts. There are two methods that can be used in order to calculate the Allowance for Doubtful Accounts account. One being the percentage of accounts receivable, the other is the percentage of sales. We will take a look at them both and look at the pros and cons of them. First, we're going to look at the accounts receivable method. We're going to start off with the percentage of accounts receivable method for a few different reasons. One, it's the one that's most often tested and two, it's the one that may be most often used in practice, often making the most sense to people that are looking at the two methods. It's also a bit more complicated, so when we're looking at test questions, they typically would focus on this method in order to have a bit more complicated process to do the calculation. It's important to note, however, that there is another method and that's going to be the revenue method or the percentage of sales method. We want to be able to compare and contrast those two. We can ask a lot of theory type questions in terms of what are the pros and cons between the two methods and there are pros and cons between the two methods. Remember that the overall goal here is to say, this is our accounts receivable account. We are recognizing that there's going to be a significant amount of these receivables that will not be collectible. Therefore, we need to tell our reader that. We need to tell our reader that for two different reasons, one being a timing issue, which is going to be on the income statement, and the other being a balance sheet issue, a point in time issue, which is the balance sheet. On the balance sheet side, which is where the accounts receivable method will be focused, we have this receivable, this asset on the books showing that people owe us this amount of money. We're telling people to read our financial statements, hey look, we're going to get this much money and therefore make decisions based on the money we're going to receive on these financial statements. However, we know that we're not going to get some of it. It's our responsibility then to show our reader, hey look, based on past experience, we believe that this amount is not going to be collectible. That's going to be one objective of the method here, either method, is to show the allowance for doubtful accounts, which will match up against the accounts receivable, the accounts receivable being a debit here, the allowance being a credit, the difference between the two, the net receivable, the amount that we actually believe that we will collect based on prior experience. That number then should be more accurate in terms of what our true assets are in the company. As we do this, we'll also be looking at the income statement side and writing off the bad debt related to the revenue. This is the part that's a bit more confusing when using the accounts receivable method, us then focusing in on the balance sheet, focusing in here on what we think is uncollectible. The byproduct of that tends to be what the bad debt will be. But they're both important because the bad debt is going to be an expense related to revenue happened in the same time period that will be decreasing the net income for the amount of this revenue during this month, this year that we think is going to be uncollectible based on past history. This concept, the income statement concept makes more sense when we look at the revenue method, which we'll take a look at later, that method then focusing here on the bad debt and matching principle of the current time period whereas the allowance method tends to focus more on the balance sheet where we are at a certain point in time, how much of the current receivables are uncollectible. Under the balance sheet method there's a couple different ways we can do this, but what we need to do is just say how much of these receivables are not going to be collectible. One common way to do that is to look at something like an aging account and try to list out these receivables in terms of how old they are and then go through past experience and say the older accounts of course are less likely to be collectible and try to figure out some type of percentages that would be reasonable, that would be uncollectible based on past experience. So if we say that here's our total here, here's our total, we're going to break that out between 30, between 30 and 60, 60 and 90 and over 90 days that something is either current or still do within 30 and then 30 and 60 past due in 60 and 90 some type of breakout in terms of time frame that we believe these accounts are past due by and thereby not judging people based on who the customer is but just by how old the accounts are as to whether they'll be collectible or not. Notice we don't have any names here, we're just recording them in terms of how old they are. So if we take this and we say okay if we go through all these accounts and we were able to break this out and of course software can do this very easily for us give us an aging account we're going to say that either current or past due for 30 days we're going to say it's current I guess and then we're going to say between 30 and 60 this is how much of this amount this one million one forty six three belongs here 60 to 90 we're saying is this amount of here of the accounts receivable falls into the 60 and 90 range and then over 90 days past due we're going to say it's the 22 926 point being is that we broke this out if we add up the 917 40 the 171 945 and the 34 389 and the 22 926 we get to the total 1 million 146 300 broken out in terms of how old this debt is then we're going to come up with some type of reasonable estimates based on how old the debt is to calculate how much will be uncollectible so if this is current or if this is 30 days past due we're going to say that 2% of it we think it's going to be uncollectible if it's current then we're saying not very much of it will be uncollectible we're hopeful that we're going to collect most of it so we're going to say that of that the 917 40 times 2% is 18341 between the 60 and 90 how old that the aging is we're going to say well these are a bit older and therefore we're going to say that 4% is not collectible because we haven't been able to collect it yet or past the collecting date due date and therefore we're going to say that 6878 is going to be not collectible and again you could ask well where do we get this 2% this 4% it's an estimate we have to come up with some reasonable estimate based on past experience and or industry standards and then we're going to say of the 34,389 10% is uncollectible based on past experience industry standards though so this times that equals to 3,439 and over 90 we're going to say is very unlikely we're going to collect it and so if we take the 229 26 times the 95 we get the 217 80 and you might be saying word of you know these you can question these percentages or whatnot but they would be based on industry standards past experience they should be reasonable in accordance with the industry based on past research if we then add these up 18341 the 6,878 the 3,439 and the 217 80 we get to the 50,437 this number then is what we believe of this number receivables people only us money will not be collectible we don't know who no names here we just know that we believe that much will be uncollectible it's a complete estimate and this is kind of disturbing to some people they say well it's just an estimate and we don't really know there's no certainty however it's more reasonable to do this we this is obviously a very significant number on the receivables we need to tell our reader that people owe us money because that's important to decision-making and we can't wait until people don't pay us that would be unfair to readers of the financial statements because we wouldn't be matching it up at the proper time period we'd be overstating the receivable so although this is an estimate it's much more fair representation as long as the estimate is fair then either not recording receivables or not recording how much we believe is going to be uncollectible so we have to come up with some type of reasonable estimate in order to make them as fair as possible now note that under this method there's already something there in the in the allowance account so we can't just use this number to make our journal entry we have to determine what we need to do in order to make this account that number we want to make this number that number so we can't just use what we came up to here that's a common error on test questions to use this number in the journal entry we have to do a subtraction problem why is there something here already because it was just an estimate from last time period and it's never going to be exact it's just an estimate so we're just updating what this allowance account should be based on our our best guess we think it should be that therefore the adjusting entry if we take out the trusty calculator it's going to be the fifty thousand four thirty seven minus the fifteen three hundred that's how much it needs to be increased by now it's possible for this account before we start to actually have a debit balance and why would that happen that would mean that in the prior time period we estimated that we had so much that would be uncollectible and more happened to be uncollectible then we had estimated flipping this account to a debit balance that doesn't happen too often but if it does and we need to get to this fifty thousand and this was a debit then we would have to credit it by something to get it back to zero and then add another fifty thousand to it in the credit direction in other words if this say was a debit balance of fifteen thousand three hundred we'd have to take the fifteen thousand three hundred plus the fifty thousand four thirty seven to get it to the credit balance of fifty thousand four thirty seven if this is a credit balance then that means that we had less people that would actually be uncollectible in the prior time period than we had estimated probably the normal case that being the normal case and therefore we have to do a safe traction problem in order to get this up to fifty thousand we need to increase this in the credit direction so if we record the journal entry then we're going to record the bad debt expense a debit here and we're going to record the credit of that thirty five thousand three seventy eight here we see that recorded out then we see that the thirty five three seventy eight and that amount is going to be on the allowance account bringing the fifteen thousand three hundred up by the thirty five three thirty five one seventy eight two fifty thousand four thirty seven that then on the trial balance on the bad debt we bring the balance up it started actually it started at zero here should have started at zero up by the thirty five one thirty seven to the thirty five one thirty seven that amount here now note what's happening here is we are recording on the revenue side the expense bringing down net income so this is the point in time that we bring down net income and this thirty five one thirty seven should be matching up to this revenue account it's less intuitive here to know that that's the case but by us making the accounts receivable correct in terms of the allowance account then the other side of it should be matching up the revenue and bad debt this will be more apparent when we focus on this side and focus less on the balance sheet in the sales method on the balance sheet side under the allowance method it seems very straightforward and very useful the balance sheet being as correct as possible by us looking at the receivable analyzing the receivable in a logical way determining how much of the receivables that are due to us will not be collectible fifty thousand four thirty seven and then showing that on the financial statements so the reader could say okay this is how much is owed to the company this is how much they believe is not going to be collectible based on a reasonable estimate of this number and therefore the net of those two is how much we are going to collect this makes good sense under the receivable method this side is more confusing under the receivable method because we're not focusing here so now we'll look at the other method which is going to be the percentage of sales method and we're just going to focus then on the receivable side again not showing as often because one it's an easier method so therefore textbooks don't focus on it to a lot of people probably intuitively look more on the balance sheet here and have the income statement kind of fall out they kind of say if I if I make the balance sheet right I make the receivable in the allowance method right then the the income statement will fall out and it'll it'll make itself work and whatever problems will happen will then roll out into the equity section after we close out the temporary accounts and will be good going forward so probably most people focus more on on making the balance sheet correct but this is going to be a valid method to the sales method and it focuses more on the income statement showing the income statement analyzing the income statement accounts and making sure the bad debt is right and letting the allowance side fall out and just be correct now one way to do it a simple way to do it would typically just be let's take a look at the revenue and take a look at a percentage of the revenue based on past experience that we believe is not going to be collectible now a lot of textbooks will basically say and in practice say we need to look at the revenue on account we need to look at those sales that we made not for cash sales but sales on account or the text might just say that we make all sales on account and therefore we can take the entire revenue amount so that's going to be a slight difference that you might see based on different textbooks or different situations in real life how would you want to do it in real life you probably want to look at those sales that are on account and then try to look at past history and see of the ones that were made on account meaning we didn't collect sale revenue at the time of the sale we collected it we're going to collect it in some other point therefore it's in receivables so how much of those sales that we make on account or we don't collect cash at the point of sale do we think are uncollectable based on past history and then if we say that it's 3% we're going to just take that number of the 378,000 times 3% 0.03 3% 0.03 gives us the 11,340 and that's it that's straightforward calculation and we're going to say that the bad debt then should be that number so the bad debt it's going to be the 11,340 and then the other side just falls out we're not focusing on the this side here the allowance we're just going to make it whatever it needs to be in order to make what we think our bad debt should be in order to have a correct matching principle for this time period so note here that we're focused on this number and we're really making net income as accurate as possible by focusing on this current revenue whereas when we focus on the accounts receivable we're really focusing on things everything that's happened up to this point in time where we stand at this point in time and therefore when we use the allowance the accounts receivable method we're kind of fixing possible errors that might have happened in the past and relooking at everything that's happened in the past to make receivables correct and this number then falling out on the income statement side we're focusing on this time period only and the side that falls out then will be the balance sheet side so this will give us more focus and it's easier to see in this method that we are indeed following the matching principle we are trying to look at this current revenue and see how much of that current revenue is not going to be collectible based on some type of reasonable estimate and therefore write off the bad debt not bad debt for sales made prior period prior month prior year but the sales that were made this year that's going to be the point and therefore net income for this time period we would think is as accurate as possible note however it still achieves the goal of making the allowance account what we think it should be it just falls out differently if we did this correctly throughout the entire period then the allowance account should fall out correctly and be correct as well meaning the accounts receivable what is owed to us minus an estimate what we think is uncollectible should still give us a reasonable estimate of what the net receivables should be if we look at a comparison between the percentage of accounts receivable and the percentage of sales method note that they're almost never going to be the same so we didn't make an example where they happen to come out the same here because it just doesn't happen typically so and here we have a different type of allowance account under the two methods and and it could be more it could be less just depending on what what time period we are using so in other words the allowance account here could be higher or lower under the accounts receivable method versus the sales method point being it'll typically be different and the bad debt same thing it'll typically be different under the two methods it could be higher it could be lower depending on what our focus is under the two methods so notice they are estimates these are both going to be estimates they're not going to be perfect and but they are better than not estimating they're better than waiting until this is going to be uncollectible and they're far better than not showing the accounts receivable at all because the readers tip real obviously want to know what the accounts receivable is how much is owed and they want some type of estimate of what is not going to be collectible also note that once we have a method here because we are using some type of estimating method we want to be consistent with that method so that we have comparison from time period to time period so if we're using a percentage of accounts receivable we typically want to use that next time period next month next year as well we're using a sales method we typically want to be consistent our goal here is to have a consistency is to have a matching principle that we can compare time period to time period going forward