Hello, I'm Professor Brian Bushee. Welcome back. Now that we have the basics of debits and credits and the financial statements under our belt, we're going to spend the rest of the course working our way around the balance sheet looking at accounts in more detail. This week, we're going to talk about accounts receivable and inventory. In this video, we're going to start with accounts receivable and look at the problem how do we account the fact that we make sales to customers on account but not all of them pay us? Let's get started. We're going to start our look at accounts receivable to see a review of the revenue recognition criteria. If you remember back to earlier in the course, we said that for revenue to be recognized, it both has to be earned, which means that the goods and services are provided and realized which means that you get payment either in cash or something that can be converted to a known amount of cash that would be like an invoice which has clear payment terms. It lays out the dollar amount and when the payment is due. That invoice of course we would call an accounts receivable, it represents the amount the customer owes us after we record the revenue. One thing that came up at the time that we're going to talk about now is that some of these customers won't actually pay us and so the big question is how do we account for this? >> Is that a rhetorical question? >> Instead of worrying about how to account for this we should worry about not selling to customers that don't pay us. Of course, companies are going to try to avoid selling to customers that won't pay them in the future. But if you try to grow a business you're going to have to take some risks on your credit sales to reach a bigger customer base. And until somebody comes up with a full proof way to avoid selling to customers that won't pay you in the future, I'm going to have to keep teaching you how to account for those customers that don't pay. There are two methods that are used to account for uncollectible accounts. An uncollectible account is when we make a sale on credit, create the accounts receivable but then never collect from the customer. The first method is called the direct write-off method. Under this method you recognize an expense when you deem the account to be uncollectible. This is the method that's used for tax reporting but it's not allowed under US GAAP or IFRS for financial reporting. >> What? >> How can the accounting for taxes be different from the accounting for financial reporting? >> And, like what do you mean by financial reporting? Hm, somebody's going to have to go back and rewatch that first week of videos. So, financial reporting is what we're doing here, putting together a set of statements for external stakeholders like investors, analysts, creditors, and so forth. The rules for tax reporting are generally different because the goal is to collect taxes. This is just one of the situations that we'll see in the course, where what you do in your financial statements is different than tax reporting and later in the course, we'll talk about how to account for these differences in the financial statement. The method that we're going to use for financial reporting which is required under GAAP and IFFS for us is called the allowance method. The allowance method forces us to recognize bad debt expense for estimated future uncollectable accounts from all the credit sales made during the period. >> Before you go on, may you please explain why we have to estimate future uncollectable accounts during the same period as the sales? The best way to think about this is the matching principle. So a cost of doing business is periodic, a cost of generating revenue is that some of the sales we made in shipping goods to our customers, those customers will not pay us. So we need to estimate the expected losses from those defaults now to match it to the revenues that we're booking this period. Another way to think about it that eventually, when we look at revenues minus expenses, it should equal the cash that we collect whether now or in the future. So by reducing the revenue by this bad debt expense, we're reducing it to an amount that equals the amount of cash that we expect to collect from all the sales that we made during the period. In addition to recognizing an expense on the income statement we're going to create an allowance for doubtful accounts to offset accounts receivable on the balance sheet. Allowance for doubtful accounts is a contra-asset which means it going to work just like accumulated depreciation. We're going to use allowance for doubtful accounts to keep track of expected reductions in accounts receivable. Instead of reducing the accounts receivable account directly. So what you'll see on the balance sheet is net accounts receivable which is equal to the gross accounts receivable the amount you originally booked when you made the sales minus this allowance for doubtful accounts. And this is completely analogous to net property plant equipment, which equals property plant equipment at its original cost minus the accumulated depreciation. So let's go through an example to see how this works. BOC makes $10 in sales on account to each of three customers: Jordan, Dakota, and Peyton. >> Not that it really matters for the example but just so I can get a mental picture are Jordan, Dakota, and Peyton, guys or gals. They can be whatever gender you want them to be. [LAUGH] One of the things that professors often do when coming up with names for examples is try to think of names that could apply to either men or women. In the old days, I would have done Chris, Pat, and Tracy. But nowadays, if you walk by any playground and you hear Jordan, Dakota, Peyton. You're just as likely to see a boy as a girl run up to the person yelling out the name. But I guess what I really need to do is try to think of internationally neutral names, so that you're not necessarily picturing little Americans in these, all these examples. In this example, we'll track how each transaction affects the balance sheet equation. So for the sales, accounts receivable goes up by 30 and revenue, which is the stockholder's equity, goes up by 30. But what companies have to do is they have to keep track of how much each individual customer owes them they can't just dump it all into an accounts receivables account. So there is a subsidiary ledger called an accounts receivable ledger, where a company would keep track of each individual customer's account. So that they know what they owe and they can record it when they pay them back. So here we have $10 receivables for Jordan, for Dakota, and for Payton, which add up to the 30 of account receivable which we're going to have on the balance sheet. As we go through this example we're not going to forget about journal entries. We're still going to use them to keep track of what's going on. So the journal entry here is debit accounts receivable 30, to increase the accounts receivable asset amount. And credit sales for 30 to increase the revenue and stockholder's equity. Now, this is combining all three sales into one. If you did it individually, you'd have three of these journal entries, one for Jordan, one for Dakota, and one for Peyton. We also are not going to forget about T-accounts. So these are the T-accounts that we're going to track through in this example. We've got accounts receivable, cash asset accounts and a sales revenue accounts. And then we're going to have an allowance for doubtful accounts contrasted accounts, so that's going to have a credit balance and a bad debt expense, expense account. >> Why is the allowance called doubtful accounts while the expense is called bad debts. >> And like, you called them uncollectible amounts before. >> Dude, what is the correct jargon? Thank you for asking that. I'm using three different names on purpose cause this is an item where companies use a lot of different terminology to represent it. You'll hear bad debts or doubtful accounts or uncollectible accounts, although. You actually won't often hear bad debt debt expense because it sounds bad. Instead you'll hear something like, provision for doubtful accounts or provision for uncollectible accounts, which sounds much more pleasant even though it means the same thing. Before we paste that sales journal entry in the T-accounts, I do want to note on here that we have to keep track of credit and cash sales separately. Cash sales of course will increase sales and increase cash, whereas credit sales will increase sales and increase accounts receivable. In the example, so far we had $30 of credit sales so that increases accounts receivable and increase the sales and we had no cash sales. And continuing on with the example, it's the end of the period and BOC has to put together financial statements. That means they're going to need an adjusting entry where they estimate how much of those sales will not be collected. Turns out their estimate is that $10 of the sales will not be collected. The way this adjusting entry would look on the Balance Sheet equation is that we create an allowance for Doubtful Accounts of 10. What that's going to do is on the Balance Sheet reduce the Gross Accounts Receivable of 30. Down to a net accounts receivable of 20, which is how much cash we actually expect to collect at the end of the period, on the stockholders equity side we recognize an expense of 10 for bad debt expense. What that'll do on the income statement is we'll have a net profit of 20, which again is how much we expect to collect from customers. In terms of the accounts receivable ledger, we don't do anything because we don't know which of these three people are not going to pay us back. And this is the whole reason for creating the allowance account. If we were going to reduce accounts receivable directly, we'd also have to reduce one of these three person's accounts so everything would add up. Since we don't know which of these three people is going to not pay us yet, we can't reduce their account directly. So instead we store up those expected losses in the allowance account. So the adjusting journal entry is we debit that debt expense for ten and we credit the allowance for doubtful accounts to increase the contra-asset by ten. >> Adjusting entries are the ones the accountant does on New Year's Eve, correct? >> Why do we not simply do the bad debt entry each time we make a sale? Now, you do realize that I was joking when I was talking about accountant's staying behind in the office to do adjusting entries on New Year's Eve, right? They actually two to four weeks after the end of the fiscal year to finish the statements. I mean, the accountant's usually the first one out the door on New Year's Eve day. We do this as an adjusting entry because we don't need to get it right until we put together financial statements. So we wait and see what the sales and receivables are for the period. And then estimate the bad debt and the allowance at the end of the period. In the next video we'll talk about the different methods we use for estimating bad debt expense and the allowance for doubtful accounts and there you'll see why it makes sense to wait until the end of the fiscal period to do these estimates. So this journal entry will be posted to T-accounts, so bad debt expense increases the allowance for doubtful accounts on the credit side, increases bad debt expense on the debit side, so we would post a 10 in both places. And then continuing on with the example. In the next period, BOC collects the cash from both Jordan and Peyton. So what we have here is cash is going to go up by 20, cause we get 10 from each and the accounts receivable go down by 20 because we no longer are owe that money by Jordan and Peyton. In the accounts receivable ledger, we can see that we reduced Jordan and Peytons account by 10, since we've collected on both of those, now they owe a 0 and that equals the total reduction of 20 in accounts receivable that we see up in the balance sheet equation. Journal entry here is pretty straight forward, we're going to debit cash because we've collected cash,. We credit Accounts receivable to reduce that asset account because we have received the cash for that 20. For the T-accounts of course the credit to Accounts Receivable and the debit to Cash are going to be 20 in this case. So, here's what our T-accounts look like after we post that journal entry. Then after 90 days, BOC finally gives up on collecting from Dakota and writes off his or her accounts receivable. So in the entry, we're going to reduce accounts receivable by ten because we're no longer going to try to collect that money. We also reduce the allowance for doubtful accounts by ten, it's no longer an allowance for doubtful accounts, it is a doubtful account. So now that we've figured out that somebody's not going to pay us, we don't need the allowance anymore, we can pull that ten out of the allowance and then directly reduce the accounts receivable. >> Now that we know Dakota is not going to pay us, why don't we have to erase the revenue from the sale to him or her? Good question. We don't erase the revenue at this point because we essentially already zeroed out this revenue when we recognized bad debt expense in the period we made the sale to Dakota. We essentially anticipated this loss as part of the bad debt expense. We just didn't know it would be the Dakota that eventually wouldn't pass. If we had a deduction to revenue at the time of the write off we'd actually be subtracting it twice. So the bottom line is that once you estimate that bad debt expense. You don't need to do anything further to revenues or expenses when the write-off happens because that write-off has already been anticipated in the estimate of the bad debt expense. If we look at the account receivable ledger, we see that we've zeroed out Dakota's account. Not because Dakota paid us but because we've given up on Dakota paying us. So we also reduced the accounts receivable by ten. So that all zeroes out accounts receivable when we add it up. The journal entry for the write-off is we debit the allowance for doubtful accounts to reduce the allowance, we don't need the allowance because we wrote off the account and we credit accounts receivable for ten to reduce accounts receivable because again we've written off Dakota's account. In the T-accounts, write-off's you can see reduce accounts receivable, reduce the allowance. So we would post 10 for each of those. Now if we look at the final totals, we've already received $20 cash and recorded $20 of pre-tax income. The accounts receivable has been zeroed out because of the 30 we originally booked when we made sales. We collected twenty in cash and then we wrote off ten as un-collectable. If you look at the allowance, it started at ten because we didn't know who was going to pay us but we thought somebody would. Then when we found out it was Dakota, we didn't need the allowance anymore so we reduced it by ten to zero it out. We have 30 of revenue, 10 of bad debt expense. That's a net of 20 of pre-tax income. And note that when all is said and done, the $20 of pre-tax income equals the cash that we actually collected. In our Accounts Receivable Ledger, everything is zeroed out at this point cause either people have paid us what they owe us, or we've written off their account, given up on ever collecting it. And then for our T-accounts we can also create balances for everything. So you can see we have an ending balance of 0 for Accounts Receivable and for the Allowance Account. Balance of 20 in cash, balance of 30 of sales and a balance of 10 for bad debt expense. >> What shall we do if Dakota pays us now? >> Do we refuse to accept her, or his, payment because we have written off the receivable? No, I would actually take the cash from the Dakota if he or she is willing to pay us at this point. Even though it makes the accounting a little trickier it's nice to have the cash. [SOUND] So let's take a look at what happens if the Dakota later pays us. After the write-off Dakota won the lottery and one of the first things Dakota decided to do was pay us the $10 that he or she owes us. This would be an unexpected recovery. We need to debit accounts receivable for ten to restore Dakota's accounts receivable. We also need to credit the allowance for doubtful accounts for ten to restore the allowance for someone not paying us. Initially we thought it was Dakota that was not going to pay us but we found out Dakota actually came through so we have to put the allowance back to have it there for someone else to not pay us in the future. >> Wait! >> Like we do not have any more receivables outstanding! Yeah, the problem with this example was that we made only three sales and then we were done. In practice, companies would continue to make new credit sales all the time and continue to add to the allowance. So if a company had an unexpected recovery of something they wrote off. They would just restore the allowance, so it would be there for when someone else defaults on their sale and if enough on expected recoveries happen and the allowance gets too big. The company can just reduce the amount of bad debt expense they put in. Which would make sense because their collections are becoming better than they thought they would be. Now that we have restored the accounts receivable, we can go ahead and record the cash collection. So we debit cash for ten, because we received $10 of cash from Dakota. And we credit the accounts receivables for ten to represent that we've collected the cash on the receivable that we recreated through the prior entry. So recoveries require two entries, so looking at the T-account. First you have to restore the accounts receivable and restore the allowance. Then you can go ahead and record the cash collection, where you reduce the receivable, basically zero it out again and record the cash. So hopefully this example gave you a good sense of how all these activities related to estimating and recognizing bad debts flow through T0accounts and journal entries. Now what we need to do is talk about how do we estimate the dollar amount of these uncollectable accounts, and that's what we're going to do next video. I'll see you then. >> See you next video!
