 Hello and welcome to the session. This is Professor Farhad and the session we would look at the allowance method. This topic is covered in introductory accounting course as well as the CPA exam, the 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 1600 plus accounting, auditing, tax and finance lectures. This is a list of all the courses that I cover, including many CPA questions. If you like my recordings, please like them. Click on the like button. It doesn't cost you anything. Share them. Put them in playlist. If they benefit you, simply put, they might benefit other people. So please share the wealth, especially these days when the coronavirus is out there. Connect with me on Instagram. On my website, you will find additional resources if you'd like to supplement your accounting education and your CPA exam. I strongly suggest you check out my website. Before we look at the allowance method, it's very important to understand or revisit fairly quickly the direct try-off method, which we covered in the prior session, but I'm going to cover briefly here to put things into perspective. How does the direct try-off method work? Well, let's assume we sold $520 worth of goods to Jay Kent on August 1st, year one. So here's what we do. We debit account receivable Jay Kent. We credit sales 520. Done. Well, we kept billing Jay Kent, and Jay Kent did not pay the bill. On January 23rd, we had a meeting the year two, and we determined, management determined, that we're going to give up on Jay Kent because Jay Kent is no longer, you know, we don't think that Jay Kent is going to pay us. At this point, we will write off the account. So listen to me carefully. When did we decide to do so? It's when we determined that we can no longer collect the account. Therefore, at this point, we will debit an expense, and we will credit, remove the account spable. Basically, Jay Kent receivable is gone. So this is basically the direct try-off method, very simple method, very simple straightforward method. So we notice the specific customer, that the specific customer is noted in the transaction, so we can make the proper entry in the subsidiary ledger. Simply put, we took Jay Kent out. So this is basically the direct try-off method. Then we talked about why the direct try-off method is not, is not a gap method. And one of the reasons, main reasons is it doesn't follow the expense recognition or the matching principle. So the expense principle requires that expenses be reported in the same period as sales. So expenses and sales, they need to be reported in the same period. The direct try-off method doesn't do that. Therefore, it's not a gap. Remember, in year one, the sale took place, in year two, the expense took place. So the sale took place in August of year one, August of year one, and let me just write this down. So the sales took place year one, in August, the expense took place in year two, in January. And this is the problem with the direct try-off method. So the expense and the sale are in two different period. Now, materiality constraint permit the direct try-off if it gives you the same result as the allowance, which we did not learn about the allowance, but if the same as the direct try-off, then you could use the direct try-off method. So usually the direct try-off method does not best match sales with expenses. So that's the problem with the direct try-off method. Therefore, if that's the problem, we need another gap method. And the other gap method that we need to learn about today is the allowance method. And this is the gap method. So how does the allowance method solve this problem? Well, here's what's going to happen. At the end of each accounting period, we estimate total debt expected to be realized from the period sales. So at the end of the period, we will just guess, take a guess. This is how much we're going to have that expense. Very interesting, not accurate, but more relevant. It's more timely. We record the expense in the same period, although we're not accurate, but we will estimate. The keyword is estimate. So two advantages to the allowance method. First, it record that expense in the same period when the sales took place. So the expense is matched with the sale. So that's the key of the allowance method. And it report a count receivable at what we call the estimated amount to be collected, cash to be collected. And we're going to see what does that mean. It means it record the account receivable net of any allowance, net of any allowance. And the best way to illustrate this is to start to look at examples to see how this all work together. So the first example is, let's assume Techcom company had credit sales of 300,000 during its first year of operation. At the end of the first year, 20,000 of credit sales remained in collected. So simply put, we still have 20,000 of account receivable. If they are uncollected, well, if they remain uncollected, they're account receivable based on experience of similar businesses. So they look at similar businesses and they estimated of that amount, 1,500 of this account receivable will be in collectible. So they guessed, they said we have 20,000 of account receivable and they say of this amount, 1,500 we are never going to collect. So what do they do? We now record a bad debt expense. So we debit, we debit that that expense. Notice they debited the expense before anything happens. They debited the expense before anything happened. And they credited an account called allowance for doubtful accounts allowance for doubtful accounts allowance for doubtful account. I'm going to be referring to with ADA. What type of account is this ADA? Allowance for doubtful account is a contra asset, specifically the asset that's reducing its account receivable. It reduces account receivable just like accumulated depreciation reduces fixed asset. This is a contra asset to receivable. So this is the entry to record, to estimate to record that expense. Now here's what how things looks like. We still have, we still have an account receivable of 20,000. So the account receivable is still 20,000. That does not change. And what we do have now is allowance for doubtful account, a new account with a balance of 1,500. And this balance, as I told you, it served to it exists to serve this account. Now, how do we present this information on the balance sheet? This is how we can present it. We would still show the account receivable at 20,000 less the allowance. So this is the amount that the expected to be collected. So this is the amount that's expected to be collected, expected to be collected in cash, expected to be collected. This is called the NRV or the net realizable value net realizable value NRV. So we have 20,000 of receivable of which only 18,500 we expect to collect. And this is an advantage of the allowance method because it shows you account receivable at net realizable value. Another way to show this same information. Some companies, what they do, it's one line. They say account receivable net of doubtful account 18,500. It means the gross is 20,000. Net of 1,500 will give you 18,500. Two ways to show this information. Now we're going to keep on going. Now we have receivable of 20,000. We estimate not to collect 15,000. Now we came to the conclusion that one of our customers, remember Jay Kent, now we came up with the conclusion that Jay Kent is basically a deadbeat. Jay Kent will not be able to pay his $520. What do we do when we determine an account becomes incollectible? Very important. That's going to be different than the direct try-off method. Once we determine an account is incollectible, we will debit allowance for doubtful account and we credit the account receivable for Kent. What I want you to notice, no expense. When we write off an account, when we write off an account, there's no expense under the allowance method. Why? Why? Because the expense took place when we booked the transaction at the end of the year. At the end of the year, December 31st, we booked the expense up front. We already recorded the expense before it actually happens. Now, how things look like now? Well, here's how things look like. Account receivable is reduced by $520 and allowance for doubtful account is reduced by $520. Now I'm going to focus on the allowance of doubtful account and I'm going to give you some very important rules. So please listen carefully and take notes as I'm going over those rules. If I ask you right now, what is the balance in the allowance of doubtful account? Well, $1,500 credit, $520 debit, the balance is $980 credit. So I have a balance of $980 credit. Let's assume we end up the year with this balance. Simply put, what I'm saying is no other customer, no other customer failed to pay, all the other customers paid on time. Therefore, we did not have any reason to write off any account. What does that mean if we have a credit balance? Please write this down. Please write this down. So a credit balance in ADA, in the allowance, ADA allowance for doubtful accounts means we overestimated. All what we're saying in the prior year, we thought $1,500 would go in-collectable, we only were not able to collect $520. Therefore, we have a remaining balance of $980. Well, what does it mean if we end up with a debit balance? And I'm going to show you what does it mean in ADA. A debit balance in ADA means we underestimated the allowance. We underestimated. We thought it's going to be $1,500. It was more than $1,500. What does it mean underestimated? Let me erase the ink and show you what happens. So I'm going to just erase the link. So please take the notes down. So let's assume another customer bailed out on us. So let's assume September 1st, one of our large customers owes us $2,000 bailed out. Therefore, we debit allowance for doubtful account, $2,000, and we credit the account receivable forehead. It's me. I did not pay my bill, $2,000. Now we credit account receivable, $2,000, and we debit allowance for doubtful account, $2,000. Now what happened is this. Now we have a debit balance in the allowance. Let's assume that's the only thing that happened. I'm the only person who ended up not paying their bill. And what does that mean? It means my balance in the allowance is $1,020. I end up the year with $1,020 debit. Well, what does it mean? It means I underestimated. I have a debit balance in the allowance. It means I underestimated. So it's very important to understand what does a debit balance in allowance mean? And what does a credit balance mean? So you're going to thank me in a moment when I go over the specific rules. So this is what it means. If you have a credit balance or a debit balance at the end of the year. Okay. Let's move on. So notice before the write-off and after the write-off, the realizable value or the net realizable value is the same. Before we wrote off J-Kent account, the account receivable was $20. The allowance was $15. The net realizable value was $18,000. After the write-off, we reduced this account by $520. We reduced this account by $520. The net realizable value is the same. So simply put, writing off an account does not affect your net realizable value. Okay. What happened if J-Kent somehow won the lottery and they wanted to pay us back this money? Well, here's what happened on January 23rd. On January 23rd, we thought J-Kent, we gave up on J-Kent. Okay. So to help restore credit, sending a customer sometime, pay all or part of the amount owed even after it was written off. Well, let's assume on March 1st, J-Kent decided to pay the full amount. What do we have to do? Just like with the direct write-off method, we have two entries to make. Two entries to make. One is to reverse this entry. That's why I placed this entry here. One is to reverse it. So the first thing is we debit the account receivable J-Kent. We credit the allowance. We'll do the opposite of what we did here. Therefore, we eliminate those two entries, eliminated each other. Then we accept the cash, debit the cash, credit the receivable. Now we restored the account. Now let's be more specific. How do companies estimate that expense? There are two methods to estimate that expense using the allowance method. There's the percentage of sales in the account receivable method. We have two submethods under the account receivable. Under the percentage of sales, put down one step easy. It's one step and it's an easy method and you're going to see why. Under the account receivable, just put down two steps. So we're going to have to compute, we're going to have to undertake two steps and you will see what I mean. Under the account receivable, we could either use the percentage of receivable or the aging of receivable. Technically, they're both the same, just different way of getting to the same answer. Doesn't have to be the same answer, but different ways of getting to the answer, not the same answer. So let's start with the easy method, the percentage of sales. How does the percentage of sales work? Well, simply put, you will take current period sales and sometimes you will take current credit sales depending on what the company uses. And you multiply this by some percentage that you estimate. So this is an estimate. So you will take current period sales and you multiply it by some percentage. And basically you will get to the answer. You will get to your bad debt expense. That's what you're looking for. So if music land has credit sales of 400,000 and it's estimated that 0.6% will eventually prove in collectible. Well, how do we compute bad debt expense? We'll take 400,000 times the rate, 0.6%, 0.006 will give us 2,400. Therefore, music land will have a bad debt expense of 2,400. We'll debit that debt expense we credit allowance. And this is basically the easy percent of sales one step method. And we are simply done. We are simply done. That's basically what it takes. That's all what it takes. That's it. Now let's take a look at the percent of receivable method. Now, the percent of receivable, we compute the estimate of the allowance for doubtful account. So notice, here's what I want you to kind of think about this. Under the percentage of sales method, really we are computing bad debt expense. That's what we are computing. That's our goal. Under the allowance, under the percentage of receivable method, we are going to be computing our goal as we are computing. Really, what we are doing is we are computing the ADA. So think of it. We are computing the ADA account allowance for doubtful account. So so we compute the allowance for doubtful account ADA using two steps. The first step will take year and receivable, whatever our receivable is, and we multiply it by a percentage. Once we do so, once we do so, we're going to get, we're going to get what we call the target and the allowance for doubtful account. That's a step one. So step one is to get your target. You want to know what should your allowance be. Remember, you are computing your allowance. Then step two, because it's a two-step process, you will take the prior year allowance for doubtful account, if any. Then if it's a credit, remember, if it's a credit, it means you overestimate the prior year. Remember when I talked about, when I talked about the credit and the debit, if you have a credit, it means you overestimate and you deduct the target from the prior year balance to find your adjustment. If the prior year allowance for doubtful account is a debit, not debut, a debit, you add the target balance from the prior year to find the adjustment. Just copy this information down and it will make sense when we work in examples. So it's a two-step process. First, you find your target, whatever you want to have an ADA. That's, I call this your target, your target and ADA. Then you work backward. You would look at your prior balance and ADA. If you have a credit, you deduct the balance from the credit. If you have a debit, you add. Let's take a look at an example to illustrate this concept. Let's assume a music land has 50,000 in receivable and 200 credit balance. Now, here's what I need to tell you in the problem. If they don't tell you, if they said 200 balance, you assume it's a credit balance because the allowance will have a credit balance. So if they don't say anything, it's a credit. If it's a debit, they will specify it's a debit. What does that mean? It means you're looking at this, you're looking at a company with an account receivable of 50,000 and they have an ADA, a current ADA of 200. It means the prior year you overestimated by 200. How do we compute our adjustment? Okay. So what we do, step one is we'll take the account receivable times 5% to get to the ending balance. This is what I call the target in ADA. What does that mean? It means, it means I need to have a balance of 2,500 and ADA. If I need the balance of 2,500, all what I need is 2,300. So this is my adjustment. This is my adjustment. So let's take a look at this. So this is my prior balance. I need the balance of 2,500. My adjustment is only 2,300. Okay. So let me just show you the entry. The entry is bet that expense 2,300 allowance 2,300. Why do I only need 2,300? Because I already have 200 from the prior balance. So notice the prior balance is 200. The unadjusted prior balance is 200. Simply put, we started the year with 2,200. We thought we're going to write off 2,200. We only wrote off 2,000. We are left with 200s. We overestimated. Therefore, the following year, we do the opposite. The following year, we under, we simply, we underestimate. We underestimate. So this is basically the percent of receivable method. Another way to compute the allowance using the receivable is called aging of receivable. You are still using the receivable. But you are computing the target differently. So how does aging work? You classify each receivable by how long it's passed due. Each group of receivable is multiplied by an estimated bet that percentage. An estimated bet that for each group are totaled. We add them all together. What does that mean? Well, let's take a look at an example. Okay. Let's assume this company has a total of $50,000 of receivable. Same company. Now, what you do is you break down the receivable by each individual subsidiary. Customer, Carly, Jamie, Chavez, Belisha, Texas, and, and Zem. And this is their balance. This is their balances. Carly Abbott, $5,890, Jamie, $710, so on and so forth. What you do next is you age the receivable. You will determine how long each balance has been outstanding. So let's see how much of the balances are not yet due. Okay. For example, Carly owes us $5,890, none of it is due yet. Jamie Allen, it's not yet due. It's not. It's it's under the other category. It's heading Chavez of the $10,500, $10,300 not yet due because we give them 30 days to pay and there's $200 and Zem services of the $21,000 that we owed them. $20,810 not yet due. And we can take a look at the rest at the remainder. So notice Jamie Allen, the $710, it's way past due. Chavez, the remaining $200 is one to 30 days past due. Texas, they have $6,110, 30 days past due, $31 to 60 days, $2,990. So what we do is we age them. Each, each receivable, how long it has been due. Then we add each group separately. For example, of the $30,000, $30,000 of it is not yet due. We multiply this by a percentage and we're going to choose 2%. How did we choose 2%? We just estimated it's 2%. Now we came up with 740 for this group. For the one to 30 days past due, $6,500 and we multiplied by 5%. For the group, 31 to 60 days, $3,700 and we multiplied by 10%. For the 61 to 90 days, $1,900 multiplied by 25%. And we have $900 that's over 90 days past due and we multiplied it by 40%. Now notice, as the amount is, is taking us longer and longer to collect, the, the, the, the probability of not collecting is higher. Therefore, what we do then, we add up all those, all those answers and they end up to be 2270. What's 2270? 2270 is the target in the allowance. So 2270 is the target in the allowance for doubtful account rather than taking, rather than taking 50,000 multiplied by, what did we multiply it by earlier? We multiply it, I believe by, by 5%. And we got a target of 2,500. What we do now, we compute this account differently. And now the target is 2270. Those will not equal to each other. If they equal, it's by just random. Okay. If, if they equal, it's random. So now what we need to do, we need to take a look at the prior balance. The prior balance is 200. We need the target balance of 2270. So here's what we have. We have an ADA with the prior balance of 200. We need a target balance of 2270. Well, if that's the case, that's easy. Oh, what I have to do is find the difference because it's a credit balance and the difference is 2,070 and that's my adjustment. So this is what I need. And my adjustment is debit, that expense, 2,070 credit allowance, 2,070 to come up with that balance. So first you figure out what's your target and from your target you work backward. Now let's assume the, we had an existing debit balance of 500. It means the prior year in the allowance for doubtful account because we never work with a debit balance. We have 500 and we did a target of 2,270. Under those circumstances, you add the two numbers to get to the adjustment. And if you add both of them, you need an adjustment of 2,770. Okay. You need enough credit to wipe out the debit and keep you with 2270 because the prior year, you underestimate it. Therefore the entry is debit, that expense, credit allowance for doubtful account. So this is the debit balance. And this is a summary of all what we learned about in this session. Basically under the allowance method, we could use the income statement or the sales method, use percentage of sales, take sales times the rate and we are done. Under the balance sheet focus or the account receivable focus, we have two methods, we have two ways to compute this, the percentage of sales. You'll take account receivable times the rate to get to the target. Then from the target, you work backward, either you deduct if it's a credit balance or you add if it's a debit balance or you take the aging of receivable by age times the rate by age, give you the allowance, then you deduct if it's a credit to get to the adjustment or add if it's a debit. So this is a summary. Now in the next session, we're going to look at notes receivable. As always, if you like this recording, please click on the like button. Just click on it. It doesn't cost you anything. I appreciate it. It helps me a lot. It helps other people subscribe. And if you're looking for additional resources for your CPA exam or for your accounting education, check out my website. Study hard and please stay safe during those corona virus days.