 Hello and welcome to this session. This is Professor Farhad. In this session, we would look at adjusting entries under the new revenue recognition rules. This topic is covered in an introductory course as well as the CPA exam far section. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,600 plus accounting, auditing, finance and tax lectures. This is a list of all the courses that I cover. If you like my lectures, please like them. Click on the like button. It doesn't cost you anything. Share them. Especially these days with the coronavirus, many students are studying online. Share the wealth. Also connect with me on Instagram. If you'd like to supplement your CPA preparation or your accounting education, please check out my website, Farhad Lecture Start. So let's take a look at adjusting entries under the new revenue recognition. Specifically, we're gonna be looking at sales discount. What do we have to do under the new revenue recognition? We have to estimate our sales discount. Simply put, we have to be proactive, just like we're gonna learn later about how to estimate bad debt. We have to be proactive and guess, estimate how much sales discount we are going to have. So let's take a look at an example and see how we work with this. So adjusting entries are required to estimate sales discount for the current sales period expected to be taken in future period. And if you really think about it, the reason why they want you to estimate this is because of the matching principle. So simply put, if this is year one and sales takes place in year one, all related effort or all related expenses or all related reduction in sales should take place in year one. Therefore, we have to estimate the sales discount. We have to estimate the sales discount associated with the sales. So this is the idea. The idea is to make sure the sales and the sales discount are recorded in the proper period, in the same period, basically the matching principle. So let's assume that Zmart has unadjusted a count receivable of 11,250. And assume they have an allowance for sales discount right now of zero. Simply put, their allowance is zero. They don't have any amount. In other words, they don't have any prior estimate to this period or the allowance is zero. However you wanna look at it, the allowance account is zero. Now, 2,500 of the receivable are within 2% discount period. So simply put, they have 11,250 in total receivable of which 2,500, still if the customer pays early, they're gonna get 2% off. They will get 2% off. The remainder, basically there is no discount on the, no discount on the remainder. So simply put, if we take 2,500 times 2%, we're gonna get the answer of 50. Simply put, we have to record an expected sales discount, expected. See the keyword is expected. What do I mean expected? It means it may or may not happen, but I have to be ready for it. So how do I record this expected sales discount? I will debit sales discount, which is a contra revenue, contra revenue, and I credit allowance for sales discount, which is a contra receivable. So simply put, I will reduce my receivable by $50. And obviously the other $50 is part of the sales discount that I took in the period, okay? So part of the 6,300. So this is the entry to proactively record sales expected. Notice expected sales discount. Now when you receive sales discount during the period, you would record the sales discount. But at the end of the period, notice the entry takes place on December 31st. You have to estimate how much discount you are still expecting to incur in this period. Now also under the new revenue recognition principle, we have to record expected, not only discount expected returns and allowances. So notice we are being basically conservative here. We are preactively accounting for those. So what's gonna happen? The seller set up a sales refund payable. So at the end of the year, we estimate how much we're gonna have to pay back. Why? Because if somebody returned the item, or if we give them a discount, we have to give them back money or reduce their account receivable. Therefore we set up a sales refund payable, which is a current liability reflecting the amount expected to be refunded. So what is that sales refund payable? It's how much do I need to give back to the buyer? Because they returned the item, they don't like it. So company estimates that future sales refund to be 1200. How did they find this out? They estimate, they took their best guess. This is all what they know based on prior experience, based on similar companies, based on last year performance, 1200. And let's assume the unadjusted, so this is important, the unadjusted balance in the sales refund is 300. So a sales refund is a liability. So simply put, if we look at the T account, we already have 300 in this account that's called sales refund. We already have 300. And what we are saying here, we're supposed to have 1200 for this year. Why? Because this is our estimate. Well, how do we go from 300, 300 to 1200? Because that's what's supposed to be the balance. And the answer is, we're supposed to book 900 of sales refund receivable. So how do we book the 900? We debit. Sales returns and allowances, which is a contra revenue, contra revenue. And we credit the liability. This is a liability for 900. Why for 900 only? Although the estimate is for 1200 because we already have 300. So last year we overestimated. So this 300 credit, it means from last year we overestimated our refund payable by $300. Now, we also have, when we estimate the customer might bring something back as a return, well, guess what? We're gonna have to accept the item and put it back into inventory. What we have to do, the sellers also set up an inventory return estimated account. So we estimate that we're gonna have to pay them back, which it makes sense. If we have to pay back the customer, well, that's clearly reflected in the refund, but also the customer is gonna give us back the inventory and we're gonna assume it's still in good condition. Therefore, we have to set up an account called inventory return estimated, which is a current asset reflecting the inventory estimated to be returned to us. So the company estimate that future inventory return to be 500. Well, unadjusted balance in that account is 200. So this is, again, this is an asset. So this is estimated inventory, estimated inventory. I already have 200 in that account from last year and now I need a balance of 500. Well, if that's the case, if that's what I need, I need the difference, I need the 300 adjustment to this account. Therefore, my adjustment is 300. Therefore, I debit inventory return estimated 300 and I credit cost of goods sold because if they return the inventory to me, it means my cost, it's gonna go down because it's no longer cost. Now it's back to an asset. So the cost turn into an asset. Now the best way to illustrate those concepts is just to work a quick example, couple examples to see how it all fits together. So we have Med Labs has the following December 31st, year end, unadjusted balances. They have the allowance is zero, which is good. The count receivable is 5,000. Of the 5,000, 1,000 is within the 2% discount period. So 1,000 of these amount, if they paid early within the discount period that's still available to them, they're gonna get 2% off. So we expect to have to grant $20 in discount. So the first question is, prepare the December 31st year end adjusting the entry. Well, if I expect $20 of discount, I have to debit sales discount at the end of the year, $20. And I have to credit allowance for sales discount $20. So that's A. Assume the same as above and there is a $5 in the allowance. Now what they're saying is this, this in question B they're saying, assume in the allowance account in the allowance for sales discount, you already have $5. You already have a balance of $5. Well, if I have a balance of $5 and I need to get a balance of $20 because that's what my ending balance is. Well, how much am I missing? I'm missing $15. Therefore I debit sales discount $15, credit, sales allowance for sales discount $15. The third question is the allowance for sales discount, a contra asset or a contra liability? Well, it's contra asset and specifically contra asset to a count receivable. So simply put, we have 5,000 of receivable. That's our receivable. What's going to happen? We're going to deduct from it. We're going to show the deducting of $20. This is the discount and therefore our receivable is 4,980. That's the net receivable net of the discount. It's A, it's a discount. It's a contra receivable. Let's take a look at another example that deals with returns. Chico company allows its customer to return merchandise within 30 days of purchase. At December 31st of its first year of operation, so we don't have any prior balance, Chico estimate that future merchandise to be 60,000, the cost is 22,500. A few days later, January 3rd, the customer returned the merchandise with a selling price of 2,000 for a cash refund. It seems they paid in cash. The return merchandise cost is 750 and it's returned to inventory as it's not defective. So let's see what we are being asked to do. Prepare to the December 31st year end adjustment for the estimated sales return and allowances. Well, I expect to have 60,000 of sales return. What do I need to do? I need to prepare an adjusting entry. I need to debit sales returns and allowances, 60,000. I need to credit sales refund table. If I expect customers to bring back 60,000 worth of sales return, I have to create a liability. I have to say I'm gonna be receiving this money. I'm gonna be receiving those merchandise, those returns back, I have to pay back the money. Now, the cost for those sales is only 22,500, which is given to us. We have to debit inventory estimated, which is inventory return estimated and reduce our cost. So this is to take care to make the adjusting entry to do two things. One is to estimate the 60,000 returns and estimate the inventory that's gonna be put back in our warehouse of 22,500. So let's take a look on the January 3rd. What happened January 3rd? The customer returned 2,000 worth of merchandise for cash. We have to give them back the money. Therefore, we reduce our payable, reduce our payable by 2,000 and we give them back the cash. Now, the inventory is 4,750. It's still in good condition. We debit the inventory account and we credit our cost of goods sold. So this is basically how we process those returns. If you need any additional supplemental material, please go to my website, farhatlectures.com, especially if you're studying for your CPA exam. It's worth it to study hard and pass. Your CPA exam is a 20 to 30 year or 40 year investment in your career. Take it seriously, study hard, good luck and stay safe.