 Hello in this presentation. We're going to take a look at the allowance method Which is of course related to the accounts receivable account? We will be able to define the allowance method record transactions related to recording bad debt Recording a receivable account that has been determined to be uncollectible Recording a receivable account that has been collected after being determined that it was uncollectible So we're going to take a look at some different transactions the most common Transactions when dealing with the allowance method and see what those look like and why we use the allowance method We're going to work through a problem. So what we're going to have here is we've got our accounting equation Of course, we have our trial balance I do suggest working problems to take a look at a trial balance because it can give you the context In which to work problems. So here's what we have we've got the assets in green The liabilities are going to be orange the light blue is the capital account and the equity section And then we have the income statement in the darker blue, which is going to be the revenue and the expenses We can see in this example. We have net income the net income is going to be calculated as revenue Minus expenses. We don't have any expenses at this time. We're just going to note this revenue number so that when we work through the problem We can see what the effect is on net income Note that we're representing debits with positive numbers or non-bracketed numbers and credits with bracketed numbers that allows us to have lesser columns and use this quick worksheet to Calculate the balancing of the debits and the credits by having the debits minus the credits equals zero So that's what we have here. We are going to be focusing in on the receivable section, of course and we're going to post transactions to this trial balance to see the Adjustment in relation to the trial balance then we'll also look at the accounts related to the Receivable accounts. So oftentimes, we'll take a look at the general ledger There's going to be a general ledger account, of course related to all Types of accounts all accounts on the trial balance will have a general ledger account, which will be in order by date We're only going to look at the two general ledger accounts that we're going to be working with in this problem being Accounts receivable and the allowance account. So those are the two we're going to look at of course Don't just keep in mind that there's going to be other general ledger accounts for all of the accounts on the trial balance Then we're going to take a look at the accounts receivable subsidiary ledger So remember that the subsidiary ledger is going to give the same detail. That's basically in the general ledger However, instead of just breaking it out by date. It's going to break it out by Customer who owes the company money. So remember the questions that will happen in relation to the receivable We're going to ask well who owes the people owes money. Yeah, people owes 1,200 Who owes this money for that we go to the receivable account So we just got these generic names. These are our customers g company d company g g owes is 30 Bd owes is 8 cb owes is 0 kt owes is 3,000 m owes is 4 Cw owes is 9 p owes is 6 7 and all other vendors note that this thing are customers all other customers Know that this thing could be very long this subsidiary ledger could be very long And we could have a professional accounts receivable Employee just tracking this information, which would be dealing with this report a lot all other customers add up to 1 million 139 3 and that means that if we add all those up it adds up to 1 million 2 so note that the Receivable subsidiary ledger ties out to the general ledger ties out to the trial balance Now the new account we have here will be the allowance account here So now we have an allowance account note that it's still green It's an asset account, but it has brackets meaning it's a credit balance account. So it's a contra asset account. It's an asset account that has a Jack credit balance, which is contra to the norm, which is normally a debit balance in asset accounts So the question many times when I teach a cruel accounting to new students They often think that the way we recognize revenue is overstating revenue under an accrual basis because When we do work on account We're gonna increase revenue and we increase the assets by increasing debit and receivables and crediting revenue And if we haven't received the money there could be a valid argument to say well Yeah, we did the work and you can say we earned it But it's it could very well be that we never get the money And if we're recognizing revenue at the point of sale before we get the money then isn't it true that we're probably Gonna be overstating revenue by those revenues that we're not gonna receive in cash And isn't it true that the accounts receivables gonna be overstated by the amount that we're not gonna get you're reporting this asset of 1,000,200 on the books pretty large asset Are you sure you're gonna get all that aren't we overstating and isn't there a generally accepted accounting principle that basically says that we want to be Error on the conservative side meaning when we talk about conservatives is Conservatism in this case. We don't mean political conservatism. We mean that we'd rather err on the side of Looking kind of worse meaning assets being understated and liabilities being overstated Rather than the other way around because From a generally accepted accounting principle these statements are being geared towards outside users being stockholders and creditors and We don't want to overstate our position to them So you can see from a regulatory body They would rather us error on the side of Understating that the receivable and it would seem that the accrual method does the exact opposite And it's not till this point that we can kind of talk about how the generally accepted accounting principles deals with that and the way They deal with that is they say that We need to account for that. We need to say, hey, you know what? Yeah, people It was 1,000,200 but we believe that in this case 40,000 is going to be uncollectible How do we know that we're going to talk a bit more about that towards the end? But the general idea the general principle will be that we need to tell our readers that We believe that Certain amount is going to be uncollectible. So if it's going to be significant if the amount is significant The generally accepted accounting principles requires us to use the allowance method rather than the direct write-off method The allowance method is this method. We're looking at here, which says that We're going to have to report the amount of the receivable that we think is going to be uncollectible so Under the direct write-off method by contrast what would happen is for example if this individual CW company Could not pay CW company went bankrupt or whatever we determined that this company is not going to pay us When they come to us and tell us, okay, we're not going to pay us We're gonna look at their accounts receivable and say, all right. Yeah, they owe us 9,000 We need to make that go down. So the receivable accounts going to go down when that happens Under under either method we use we know we got to take it out of the receivable because we have now determined We're not going to receive it. Therefore. We're going to credit the receivable Where should the debit go and if you think about it what really happened if we're not going to get paid by a Client or customer it means that we overstated revenue at some point in the past in the past We overstated revenue because we increased revenue by a sale That's not really gonna happen didn't really it's not really a sale if we're never going to get paid for it So you would think that the debit would go to revenue which would reduce revenue because we overstated revenue There's a couple problems with that However, one is that we don't like to decrease revenue directly remember that revenue basically always goes up and we almost never debit revenue So and so therefore we make another account with that other accounts going to be called bad debt expense So the expense is going to go up which brings down net income So under the direct write-off method, that's what would happen We would take it out of the the receivable and we would record the expense when it is determined that The clients not going to pay us and we wouldn't have this allowance account at all We wouldn't have it here and now the a fairly simple method That's the easiest method to do if the receivables are in material in in decision making then we can't use that method But if the receivables are material, there's another problem here and that is that Note that if we write off this 9,000 that we we wrote into revenue last year It was part of revenue last year and we're writing the expense related to it or the reduction in net income This year then we're violating the matching principle because we're reducing it in relation to this income But the 9,000 isn't included in this income. It's not included in this 379 378 Because it was earned we recorded an income last period and we already closed that out to the capital retained earnings account so That means that that that's the problem. So Under the accrual method what we want to do is match the expense with the revenue So we want to look at the same time period and say, okay I'm gonna I'm gonna say that this amount is going to be uncollectable in relation to this revenue And that's gonna be an estimate. So we had to make an estimate and do that We'll talk more about how the estimate will work later But just note that at the end of last period We made an estimate and we said okay of the 1,000,000 to that is outstanding We believe that 40,000 is not going to be collectible and now when someone comes to us and says that they're not gonna pay us The 9,000 then instead of debiting the expense at that point of time We're just gonna debit the allowance. So it would look like this So under the allowance method when someone a customer is determined that they will not pay us then We're gonna reduce the receivable with a credit the debit will go to the allowance account What will that look like in terms of the trial balance? Well, we can see here that the receivable is gonna be credited So that's gonna go down. So obviously that has to go down and all we're gonna do on the other side is We're just going to debit the allowance the allowance has a credit balance We're gonna debit doing the opposite thing to it, which will make it go down Notice that the the book value of the receivables the net value is going to be unchanged because it was before 1,000,000 to minus the 40 that's the net value and now Receivables went down and so did the allowance. So therefore now it's the 1,000,000 91 minus the 30 the 31 so notice there's no effect on net income down here And that is because we basically already wrote off This 9,000 included in the 40,000 last time period When we when we created the allowance account and we'll do that again at the end of this of this presentation So you can see if we go through our series of questions and we're gonna ask well, do people owe us money? Yeah, the trial balance says that people owe us one million one ninety one Well, who owes us some money? Well, if we look at the GL account, it doesn't tell us that if we look at the GL account it just tells us by date that we had 1,000,000 to and it went down by 9 We look at the GL account for the allowance We can see that that's basically telling us that this was an amount that was not paid And we had to write it off even though we were not paid for it And then so we're gonna have to look at the subsidiary ledger, which is in order by a customer So if we look at the customer in this case, we're gonna say that CW is the one that we are writing off So this nine here is also recorded here, and it's also recorded here So this is the same information that is now recorded in terms of customers And then if you take that off now CW owes us zero and if we add up all the customers Then it adds up to one million one ninety one Those are the people that owe us money that ties out to the general ledger that ties out to the receivable Account here and note that we have 31,000 that we do not believe is collectible We cannot apply that 31 to any of the actual customers because it's just an estimate We don't know who's not gonna pay us We just believe that certain amount of folks aren't gonna pay us based on prior experience So now we have a G company made a partial payment and when bankrupt is determined that we will not receive the balance So we're gonna receive 20,000 of cash and then we're not gonna receive the other 10 So if we look at G here, we could see that they Company owes us 30,000 they're gonna go bankrupt and they're in within the bankruptcy assuming they Paid off who they could which they paid off us 20 and then they're not gonna pay the rest because they went bankrupt So that is what's happened if we go through our series of questions Then we can say well is cash affected in this case it is we got 20,000 So we're gonna increase cash. It's gonna go up in the debit direction by 20 Normally when we get paid the normal credit will go to in this case Receivables because that's why they paid us they paid us to pay off the receivable. So the receivable has a debit balance We're gonna make it go down by crediting it. However, we're not gonna credit it by the 20 We need to credit it by the entire amount owed which is the 30 and the reason for that is because if we only Accredited by 20 then we would show the G owes us 10 still and they don't or they're not gonna pay us So we got to write that off So therefore we're gonna have a difference and we're gonna need another debit. Where will that debit go? That is gonna be the un-collectible portion which we're gonna put into the allowance method Remember under the direct write-off method that debit would go to the bad debt expense at the time It was un-collectible or determined to be un-collectible under the allowance method We already have this 31,000 we already we already estimated that that 10,000 wasn't gonna be collectible We just didn't know who was not gonna collect it We already wrote it off in the prior period to match it to the income that was generated in the prior period And now we're just going to take it to the allowance a journal entry would look like this We have the debit to cash cash is going up by the 20,000 We're gonna credit the receivable for the entire 30 and then the difference is going to the allowance to debit here We can see that the 20 plus the 10 equals the 30 that debits equal the credits also note that I put it in this order because this Is the order that it when I think through the journal entry That's the order that works best for me to think through it However, if you're gonna post this to something that's gonna grade you on Having the debits on top you might want to put two debits on top If it helps you to audit or something like that and go back to the information and look at it Then I would record it in whatever way helps you to think through the process All right, so if we're gonna record that in terms of the trial balance It would look something like this the cash is gonna be debited so it's going from 100 plus to 20 it's gonna go up or doing the same thing to it So we're debiting a debit bounce count increasing it the receivable is gonna go down So we have the debit here. We are crediting it doing the opposite to it Bringing the receivable down by the 30 and then that difference is going to go to the allowance So notice the allowance is a contra count meaning it's an asset with a credit balance We're debiting it doing the opposite thing to it bringing it down So then if we think of our questions, do people owe us money? Yeah, people owe us one million one sixty one Who owes us money? Well, if we look at the general ledger, it tells us detail But it only tells us the activity by date So we had people just one million two then we had those nine thousand that it went down by and then we had The 30 that it went down by normally that would be from payments In this case it went down because we were not paid and we were or we weren't paid on all that We got we got 20 out of the 30 on this one, but some of them were due to writing it down We also have the allowance here showing this activity. Here's where the 10 is being posted to the allowance Here's of course where the 30 is being posted to the general ledger now If we want to know who owes us money, we would have to go to the subsidiary ledger So in this case note that this 30,000 is being recorded in G's account, so they owed us 30 now They paid us 10 and we wrote off I mean they paid us 20 and we wrote off the other 10 because we determined it was not going to be collectible That's back down to zero if we add up all customers then it will add up to one million one sixty one That ties out to the general ledger of that ties out to the trial balance of that We still have this estimate of 21 that will be that not collectible So the reason it went from the the prior balance when we started this which was 40 and now it's going down It's because We're now know who's not going to pay us So this was the estimate and we didn't know who wasn't going to pay us now We have determined that these amounts are uncollectible and we're writing it off Against that 40,000 and then applying it out to the correct customers, which are now determined to be uncollectible All right next item received payment from CW after we had assumed the bad debt Uncollectible had been written off. So in this case what we're saying is that this is an unusual case But it's good to look at because it kind of shows us what would happen If someone came in the door and said here I am I'm gonna pay you now And we had totally wrote them off in the past because we didn't think that we were gonna get paid from them So in this case remember that the CW company owed us 9,000 We determined we're not gonna get paid that we wrote off the 9,000 to the allowance account here So we wrote them off and now they came in the door and said, you know, I showed up out of nowhere You haven't been returning our calls and whatnot, but here I am and I'm gonna pay you the night out. That's great So how would we record that I'm gonna tell you the way not to do it first And then I'm gonna tell you why it doesn't work that way So one way that it would you know, it kind of works, but it's not the way we're gonna do it Is that we can take it through our transactions and say well is cash affected? Yeah, we're gonna debit cash because we got cash from the clients and we would normal credit a receivable However, we cannot credit the receivable now because we already wrote the receivable off Where did we write the receivable off to we wrote it off to the allowance account? So therefore since we already wrote we can see this 9,000 was written off to the allowance account Why don't we just debit cash and credit the allowance account which would cancel out this 9,000 that we wrote off here that would work and That works in terms of journal entries. However, it doesn't really work in the system Because if we then look analyze the receivable account It looks like this payment was not paid. It looks like the customer is Kind of like a deadbeat and so if they came to us again, we don't have an audit trail in their subsidiary ledger showing that they actually paid us it looks like they never paid us So what we want to do is record this activity in the subsidiary ledger and have an audit trail on it therefore instead of doing that that we're gonna kind of break the rule of Thinking about cash first and in this case, we're gonna say well Let's reverse what we did last time as of today. We're not gonna we're not gonna go back in time and do it We're gonna say as of today. We're gonna reverse the prior journal entry putting this customer back in good standings on the subsidiary ledger and then we'll do the normal Transaction which would be to debit cash and credit receivable. So that would look like this. So We're gonna reverse the what we did last time which was to write off the receivable We're gonna put the receivable back on the books by debiting the 9,000 to put the receivable back in good standing here And then we're gonna credit the allowance account. So we've reversed what we did last time now We're in our normal circumstance now We're back to the norm and now we can then debit the cash like we normally would when we get money from a client and Credit the receivable reducing the receivable So it would look like this the cash is is going to the receivable is gonna go up by the 9,000 And then the allowance is going to be credited by the 9,000 Then we're gonna debit the checking account by the 9,000 and credit the receivable by the 9,000 Note the net difference in the receivable is is zero. It went up and down Therefore in terms of journal entries, we could simplify the journal entry a lot by just debiting cash and Crediting the allowance. You'll note in essence. That's what we did here. That's what happened But why don't we do that? Well, let's look what happened on the general ledger And that is that the receivable went back up here We debited the receivable here and then we credited the receivable So we put the we put it back in good standing and then we took it off and kind of the normal process on the allowance account We can see that we reversed the allowance account here and then on the subsidiary ledger What happened for CW is note that we put the 9,000 back on the books as being owed to us and then we wrote it we wrote it off here So the reason for that is we if we look here, then the audit trail will basically show us that Yeah, we wrote it off But then we put them back in good standing and then this 9,000 if we you know if we check the audit trail on that from the subsidiary ledger It'll show a payment Whereas if we didn't do these two transactions and we just looked at this item and we checked the audit trail It would show that There was no payment. We wrote it off. So that audit trails pretty much the reason why we would do this reversing process instead of just having a simple Journal entry that that would just be half as long All right, so then we determined that P company and BD company would not pay us the amount owed so two more companies we've determined maybe at the end of the period at the end of the year or so that They're not gonna pay us. We're gonna probably analyze our receivable accounts periodically and see that Companies will not pay us and if we look at P company here We're gonna write them off so that six sevens are gonna have to go down and BD company is gonna have to go down That's the receivable accounts. So those are the amounts it will go down by therefore the receivable is gonna have to go down by that and That's gonna be a credit and then what are we gonna debit once again? We're gonna debit the allowance account So that would look like this we're gonna debit the allowance account for the 14 7 and credit the receivable and once again that adds up to the two clients see company P company and BD company the amounts that they owed and Therefore We're gonna debit the receivable. I mean credit the receivable. So the receivable is gonna go down has a debit balance we're gonna do the opposite thing to it to make it go down and Then we are going to debit the allowance account making it go down Note that there's once again no change in the net receivable because the net receivable here was a debit of the receivable of 1,161 minus the credit of the allowance that would be the net receivable and then they both went down therefore The new net receivable is now 1 million 146 3 minus the 15 3 So if we look at the activity then the questions being do people owe us money. Yeah people owe us 1 million 146 3 Well, who owes us the money the GL just tells us by date what has happened So what has happened it went by it went down by 9 it went down by 30 It went back up by 9 it went down by 9 and then we have this 14 went down by that The allowance shows us the activity for the accounts that were uncollectible then the subsidiary ledger breaks it down by Customer or client so here's what happened. There's that to 8,000 here as well as the BD&T the 6 7 that's what adds up to this 14 7 So we had to break that out between the two customers that don't pay us if we add up all the receivables then in the subsidiary ledger It adds up to 1 million 146 3 of that times out to the general ledger that ties out to the trial balance and we still have this estimate of 15 3 that we determined was uncollectible so now we're going to say it's at the end of the period if it's at the end of the period now and We're done with with the year and we need to then determine What the allowance account should be at the end of the time period? There's a couple ways we can do this if we think about this what we're saying here Is that the revenue account here of three three seventy eight thousand if we made all those sales on account? We need to think about the amounts that will be Uncollectible so part of those sales are going to be uncollectible and what we want to do is write off that Uncollectible portion this period We don't want to we don't want to close out the books and then write it off next period Because then we'll write off the bad debt expense to the next period We want to match up the uncollectible accounts to this period now. We don't know who's not going to pay us That's the problem. We know that we made a bunch of sales We don't know who's not going to pay us But we can make an estimate of that and under generally accepted accounting principles We have to because if we don't then we're going to be overstating the revenue or the net income that we have earned in this time period and we'll be overstating the assets So we have to make some kind of estimate and that's controversial because anytime you make an estimate That you know it's just an estimate and you can Be off on on an estimate It's not exact but in order to to fix the matching problem in order to present our financial statements in the most fair way and not Overstate them an estimate is better than Than not having an estimate. So how could we make an estimate one? We could look at the the revenue side here and we could say well if we made all these sales on account then Based on past experience, we could take some percentage of the revenue and say that based on past experience We have learned that this percentage is Uncollectible therefore we can write off the bad debt expense Debuting the expense increasing the expense for that percentage portion of the revenue The other way we that we can do it which I'm going to show here, which I think is probably To me it's more exact to do because it seems like you can come up to a Better estimate in this ways to actually look at the balance sheet account And that would be the receivable account here and then try to find a way to break down What portion of the receivables are going to be uncollectible and so that's often times you're going to look at something like an aging Account in order to do that. So if we have this a 1 million 146 3 if we break that out that 1 million 146 3 in terms of an accounts receivable aging Which could look something like this a lot of software will have this and stuff like QuickBooks or something can generate this report And if we have something that's 30 days passed through we can have to you know, we might say that 2% is Uncollectible if it's between 30 and 60 passed you 4% perhaps 60 and 90 10 percent perhaps and over 90 maybe there's a very high chance that it's going to be Uncollectible and this way we can break it down by how old the debt is Which is usually a fairly good indicator if it's old if the thing is older and we've been calling people forever And they haven't gotten back to us then at some point we can say yeah There's a higher likelihood or probability that you know, we're not gonna get paid on that one So where do we come up with these percentages? We would have to get those on past experience and again That's something that in a problem the book would have to give you in real life We would have to do some careful analysis in terms of how we would come up with that But if we multiply that out then we're gonna say this times this we would come up with these numbers And that would say that okay of the one million one forty six three We think based on this estimate that fifty thousand four thirty seven will be uncollectible therefore we still have fifteen three hundred in the allowance account here and That's because we basically overestimated last time We thought that we weren't gonna get I think it was forty at the at the beginning Yeah, it was forty here last time and and we're still left with fifteen three at the end Meaning that we didn't write off as many not many people came and said they were not going to be collectible as we thought Therefore in order to get this fifteen three up to the fifty We would do a subtraction problem and the difference being thirty five one Thirty seven is what we would need in order to bring that amount up to the estimate of Fifty thousand so if we posted this so if we took the fifteen thousand Mine is the fifteen three we come up with the thirty five one thirty seven So now if we post this out then we're crediting the thirty five one thirty seven to the allowance So that's going to take the fifteen three up by thirty five one thirty seven to the fifty thousand three forty seven Which matches the fifty thousand three forty seven here then the other side is finally going to go to the bad debt expense So now we're going to debit the bad debt expense by the thirty five and that's going to bring it up to thirty five And then if we look at what the effect is on net income We're going to say of this revenue here thirty five of it We believe it's going to be uncollectible meaning we're never going to get paid on that and we make that estimate Kind of like an adjusting entry as of the end of the time period So that as of the date when we create the financial statements We're showing a net income of the three forty two eight sixty three instead of the three seventy eight So we're we're recording the fact we're representing the fact that of these sales We believe this amount is going to be uncollectible on the on the balance sheet side. We're also saying Yeah, we have revenue. We have receivables of one million one forty six three However, we believe based on past experience that fifty thousand four thirty seven will be uncollectible We want to disclose that to the readers. We want to be as fair as possible and not Be overstating our value. However, it's also just an estimate and we could collect more. We could collect less That's our best guess So we are now able to define the allowance method record transactions related to recording bad debt recording a receivable account That has been determined to be uncollectible Record and receivable account that has been collected after being determined to be uncollectible