Hi.
Else here.
And in this video will be exploring the valuation
of accounts receivable at period end using the allowance method.
In my last video, I talked about the direct write off method
and how we generally can't use it
because it violates both expense and asset elements.
I asked, what method can we use so our assets are appropriately
valued in 2014 and we record our bad debt
expense in 2014, the same year as the related revenue?
That would allow us to follow the definition of both
the element assets, which need to be valued
at their future economic benefit,
and the element expense, which have
to be recorded in the same period as the related revenue.
I called it the allowance method.
Let's look at how it works.
Let's assume we're back at December 31, 2014.
Our accounts receivable are $360,000 on the balance sheet.
We know that when we sell on credit
there will always be a problem with collections.
Some of our customers will never pay.
The more we sell on credit, the greater
the risk that there will be a problem with collections.
Now, we know that some customers won't pay.
But on December 31, 2014 we can't really
say which customers won't pay.
After all, if we knew for sure that they weren't going
to pay us, we'd get rid of these accounts receivable right away.
We don't know specifics.
We just know that generally a certain amount of customers
are not going to pay.
How do companies handle this uncertainty?
Well, they guess.
When I say guess, I mean an educated guess,
one that's based on the facts from the past and expectations
about the future.
Companies look at their accounts receivable history,
at the industry overall, and finally at the economy in order
to estimate the amount of accounts receivable
that they think won't be collected in the upcoming 12
months.
Using this estimate of uncollectible accounts,
they are in a better position to value accounts
receivable at year end and to match
the expenses to the revenue it helped
to generate in that year.
Let's look at an example on how this is done.
ABC Company has accounts receivable
of $360,000 at December 31, 2014,
and revenues of $1,450,000.
Remember that this is the first year
of operations for the company.
Although management does not have much experience,
they use what's happening in their industry and the economy
to estimate that $25,000 of the current accounts
receivable of $360,000 will not be collected in the upcoming
year.
What entry should the company make?
You might say that ABC Company should decrease their accounts
receivable by $25,000.
But you would be wrong.
We don't know which customers will go bad
so we can't put our estimate against actual customer
amounts.
When we make an estimate, we can't touch the accounts
receivable account.
Instead, what we need is a contra asset
account, a negative amount that will go against accounts
receivable so that, when added together,
the accounts receivable is equal to
their future economic benefit.
That account is called the allowance
for doubtful accounts.
The short form, AFDA, or A-F-D-A.
It's a contra asset account similar to the accumulated
depreciation account that we learned about on our financial
statement video and in our adjusting entry videos.
The allowance for doubtful accounts
belongs in the element assets because it's a negative asset
account.
It's recorded immediately under accounts receivable
on the balance sheet so that accounts receivable is now
valued at its estimated future economic benefit.
OK.
That's great.
But what's the other side of the entry
to record the estimated uncollectible amount for 2014?
Under the element Assets we would record negative $25,000
to the allowance for doubtful accounts, or AFDA.
Under Equity we would record negative $25,000
to the Bad Debt expense account.
If we do this, would the problems
we discovered when we were using the direct
write off method disappear?
Yes.
Because it would reduce assets to their estimated future cash
value and match expenses to the revenues
they helped to generate in 2014.
So on our balance sheet we would show the following
under Current Assets.
Accounts Receivable $360,000, Allowance for Doubtful
Accounts, negative $25,000.
We don't have to put a negative in front
of the $25,000 because the word less is in front of the words
Allowance for Doubtful Accounts which indicates
that $25,000 is negative.
Net realizable value, the value that we'll
realize in cash over the next 12 months, is therefore $335,000.
That is a future economic benefit
that we expect to receive from these accounts receivable.
All right.
Now, on our income statement, what would show?
Revenues would be at $1,450,000.
Remember, this includes $360,000 of revenue
that we sold but have not as yet received in cash.
Expenses would include the Bad Debt expense of $25,000.
Notice the Bad Debt expense of $25,000
is recorded in the same years of related revenue.
So we are matching our expenses to the revenue
they helped to generate.
By using the allowance method we've
solved the two problems we had in 2014
and 2015 under the direct write off method.
Using the allowance method our accounts receivable are
at their future economic benefit and the expenses are
in the same years of revenues they helped to generate.
Excellent.
Moving into the next year, 2015, how
will we record write offs when they happen?
And what if a customer pays their accounts receivable
after we've written that customer off?
Well, that's the topic of our next video.