Net Accounts Receivable: Allowance for Doubtful Accounts

So when we're dealing with accounts receivable and bad debt expense gap requires us to use an allowance account. Let's check that out. So like I said Gap is requiring the use of an allowance. So what this does is it helps us conform with the matching principle. Right? When we talked about the direct right off method, the direct right off method was not Gap because it didn't follow the matching principle. Okay so bad debt expense. We talked about it a little but these are the losses that occur from extending credit to a customer but not getting paid. Right? So we sold them something and said okay you can pay us later and then they never paid us later. Well, we have bad debt expense. Okay. And usually when I write this, I'm gonna shorthand it to B. D. E. For bad debt expense. It's just a long thing to write and you can get away with B. D. All right. Just like allowance for doubtful accounts. So this is our big topic here. And we're gonna be uh short handing it as a D. A. For allowance for doubtful accounts. Well, and by the way sometimes it's called allowance for uncollectable accounts, something like that. But this is the most common format allowance for doubtful accounts. So this account it's a contra asset. Okay. We've talked about contra assets once before. Um But just so you remember a contra contra asset, they're gonna be paired with another account and in this case they're paired with accounts receivable. Okay. So what a contra asset has is an opposite balance of the actual asset. So if you think about an asset accounts receivable it's gonna have a debit balance, right? That's how we're used to accounts receivable. Well the allowance for doubtful accounts, it's gonna have a credit balance. Right? So the debit balance and accounts receivable and the credit balance in the allowance, well that credit balance is going to lower the net balance right? It's gonna bring the debit a little lower because there's some credits over here. Right? So we'll see a little more details about that. But remember contra asset they have an opposite balance than the regular account. So if I was just just for ships let's say uh a contra liability, write a contra liability while a liability has a credit balance. So contra liability would have a debit balance. Okay so let's go on here. So the allowance um what we use it for is to estimate. So the allowance helps us estimate the amount of bad debt in our accounts receivable. Right? So if you think about it we've got a certain amount of account receivable right now. Well there's going to be in that batch of account receivable. Some amount of it that's bad debt. Right. Well the allowance helps us estimate that amount. So let's see how this happens and how we follow the matching principle here. All right. So in year one we have credit sales, right? So year one notice. Year one we have credit sales. So we take an entry like debating accounts receivable and crediting revenue, right? Because this is a credit sale, we're gonna be paid sometime in the future. But we're also gonna have another entry at this point to deal with the bad debt expense. Okay. So we're gonna estimate from all these accounts receivable. We made all these credit sales and we have all these accounts receivable. We're going to estimate how much of it is not collectible. Okay, so that's what we're gonna make this second entry notice in year one, we're making an entry for bad debt expense. I didn't even abbreviate it like I wanted to well, bad debt expense and let me move these out a little bit. Uh So these were like this well, bad debt expense is gonna be debited and we're going to credit the allowance for doubtful accounts. So notice this allowance, whoops doubtful accounts. Well, I should have definitely used my Alright, I'm I'm going back and I'm using my acronyms here. Sorry, one second. All right, we're gonna change this to be d for bad debt expense. An A. D. A. For allowance for doubtful accounts. So notice we credited allowance for doubtful accounts. Right? So that was a contra asset, right? This is a credit balance that's related to our accounts receivable account. Okay, So notice what happened in year one, we took our revenue and we took a related expense. Okay, So that's the matching principle. It all happened in year one. Now notice what happens in Year two in Year two, we finally decide, hey, we're not gonna be able to collect some certain amount of that money. Well that's fine. We already took the expense. We're not gonna take an expense at this point. So notice that the expense, the bad debt expense, it got put into the allowance for doubtful accounts, right? So whenever we want to write off an account in the allowance method, we're going to debit the allowance because it's coming out of the allowance. So this will lower the balance in the allowance and we're going to credit accounts receivable right to get the account receivable off of our books. Think about it. We had this account receivable on our books and now we're finally deciding that we're not going to collect it. Well, we have to credit it to get rid of it and we already took the bad debt expense related to that account in year one. So now in year two we just have to decrease the allowance because this is us finally finding that bad debt that we expected in year one. Okay, So we would decrease the allowance and our accounts receivable in those amounts that we decided we're uncollectible and those numbers would all have to be given to you. They would have to tell you, oh, $1000 was deemed uncollectible in Year two or you know, all these things have, there's gonna be a lot that has to be given to you in these questions. All right. So when we calculate our allowance, we're gonna deal with two methods that we're gonna talk about in a separate video. The first one is the percentage of sales method. And with this method the bad debt expense is estimated as a guess what percentage of credit sales. So we're gonna have so many credit sales in this year. Say we had $1 million 3% of those are uncollectible. Right? So we'll be able to find out how much is it Collectible? Well 3% of that million. Okay. So notice in this method what we calculate is the bad debt expense and then we can find the ending balance in the allowance. Using that information. Now don't worry too much about the details. There's going to be much more detailed explanations of this. I'm just showing you the two methods here. The second one aging of receivables method. Well in this method we're gonna see how old every receivable is right? We would expect a receivable that's only been in our account for two weeks. Well we could probably still collect that but maybe a receivable that's been in the account for two years. Well, you know maybe that money is not coming in. So what we do is we use a schedule based on the age and then we estimate what the ending balance in the allowance should be. and this is based on the age of each receivable, right? So the older the receivable the more likely that we won't collect it. So in this method notice we calculate the ending balance, so the percentage of sales method, we calculate the bad debt expense, the aging of receivables. We calculate the ending balance in the allowance. Okay? And then we back into our bad debt expense. Cool. Let's pause real quick. This has been kind of a hefty topic, and then we'll do this example below. Alright, let's do that.

Alright, let's continue with this example here, a company regularly sells items on account. Currently accounts receivable total 12,000. However, the company estimates that $800 of this amount is uncollectable notice they had to just give us that information. And here we're not. We're not using either of the methods. Were not going to say Um you know, aging method. No, no, no. They just gave us this number. $800 out of that. 12,000 is uncollectable. So what we do is we need to take our bad debt expense. Let me use my acronyms. b. d. for bad debt expense. And that would be in the amount of $800. Right? That's how much we're estimating is gonna be uncollectable. And then we're going to credit our allowance for doubtful accounts, right? This contra asset that lowers the value of our receivables. Okay, so the bad debt expense, That's lowering our equity. That's an expense on the income statement for the 800 and the allowance for doubtful accounts. Well, that's lowering our net accounts receivable, which we'll talk about in just one second. So it's lowering our assets by 800 as well because we're not expecting to collect $800 of our accounts receivable. So that brings us to this last idea, the net accounts receivable. So net accounts receivable. What you you might have heard the words gross and net when we talk about gross receivables, that's the total amount. That's the amount that's in the accounts receivable account. Okay, so the accounts receivable account has all the gross receivables in it, the total amount. And then we're gonna subtract from it. The allowance for doubtful accounts. Right? Remember that these gross receivables in a are they have a debit balance? Right? And we just discussed how the A. D. A. Has a credit balance. So that's gonna lower the value of accounts receivable. And that gets us to this net accounts receivable. Okay. And that's usually what you report, you'll say something like net accounts receivable when you're listing your assets. Okay? So let's go ahead and see what the T. Accounts for these look like. Alright so remember we have our base formula, we have this base formula where we had our beginning balance plus additions to the account minus subtractions from the account equals the ending balance. And this is kind of just a generic formula that we use for pretty much every balance sheet account. Okay So let's see how this relates to accounts receivable. And the allowance for doubtful accounts. So our T. Account for accounts receivable, I'll just put a R. The T. Account. Well we're gonna have some beginning balance, right? And that's just like in every case we'll have some beginning balance or it'll be zero. And then we're gonna make credit sales right? Just like every time we had a credit sale transaction we were debating accounts receivable. So the credit sales are gonna be our additions to accounts receivable, right. That's the a over here. Uh Well every time we make a credit sale, that's gonna increase our accounts receivable. But what can reduce our our accounts receivable? Well that's when we collect right, collect cash from the customers every time we get cash from the customers, we're gonna decrease the accounts receivable. But now we've learned one more way we can decrease it with write offs right? Whenever we write off an account because we we decided that it's not gonna be collectible. Well then we can decrease accounts receivable as well. And that's gonna lead us to our ending balance and accounts receivable. So notice this right off century that I put in blue. That would be this entry I made in february year two up here notice that A. R. Is being credited right here. Right? This credit to A. R. That's because we are writing off that account and it's no longer owed to us. Well in theory it is owed to us but we're not expecting to get it. So we're taking it off of our books. Right? So that's how the accounts receivable account flows. Right? We've got our beginning balance, we're gonna add credit sales. Then we're gonna subtract any money that we did receive from the customers and we'll subtract the write offs to get to the ending balance. Now let's look at the allowance for doubtful accounts. I'll do it right here. Alright, allowance for doubtful accounts A. D. A. So remember this one starts with a credit balance right? The allowance is a credit balance account so it's generally gonna start with a credit balance. Now you're gonna see some weird problems but we don't have to deal with that. Let's talk about the real general terms here we start with the credit balance. And then what's gonna happen? What increases the allowance is when we take bad debt expense, right anytime we take bad debt expense. Well that would be like the entry that we made up here. Right? Bad debt expense, debit, bad debt expense, credit, the allowance right? It's gonna increase the allowance. Whoops. Alright. Um Yeah it's gonna increase the allowance anytime we take our bad debt expense and what's gonna lower the allowance? Well that's when we write off an account right when we write off that will lower the allowance. Okay? And that gets us to our ending balance in the allowance which should be some credit balance just like that. Alright so notice our net accounts receivable, we're gonna have this a. R. R gross accounts receivable minus the allowance and these two accounts together. Well that's our net accounts receivable. Alright let's go ahead and move on to the next video