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 the receivable account that has been determined to be uncollectible recording every single 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 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 numbers 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’re going to be focusing in on the receivable section, of course, and we’re going to post transactions to the 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, 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. Remember the questions that will happen in relation to the receivable? We’re going to ask well who owes the people’s money? Yeah, people owe us 1,000,200 who owes us money for that we go to the receivable account.
So we’re just have these generic names. These are our customers GE company D company, Joe’s 30 bd O’s is eight. CBS zero k t O’s is three things M O’s for CW O’s is nine POS is six, seven and all other vendors note that this thing our customers all other customers note 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 1,000,001 39 three, and that means that if we add all those up, it adds up to 1,000,002. 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 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 accrual 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 going to 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 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 going to be overstating revenue by those revenues that we’re not going to receive in cash? And isn’t it true that the accounts receivable is going to be overstated by the amount that we’re not going to get your reporting this asset of 1,000,200 on the books pretty large asset? Are you sure you’re going to get all that? Aren’t we overstating? And isn’t there a generally accepted accounting principle that basically says that we want to be an error on the conservative side meaning when we talk about conservative conservatism In this case, we don’t mean political conservatives. And 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 general 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 err on the side of understating 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 general 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 owe us 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, it’s going to be significant if the amount is significant. The general 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 if 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 were going to look at their accounts receivable and say, all right, yeah, they owe is 9000. We need to make that go down. So the receivable accounts going to go down, when that happens under under The 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 increase revenue by a sale, that’s not really going to happen. And 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 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 receivable and we would record the expense when it is determined that the client’s not going to pay us and we wouldn’t have this allowance account at all, we wouldn’t have it here. And that would be a fairly simple method. That’s the easiest method to do. If the receivables are in material in decision making, then we can’t use that method. But if the receivables are material, there’s another problem here. And that note that if we write off this 9000 that 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 9000 isn’t included in this income. It’s not included in this 379 378 because it was earned. We recorded it in 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 Rule method, what we want to do is match the expense with the revenue. So, we, 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 uncollectible in relation to this revenue. And that’s going to 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 1,000,002, 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 going to pay us the 9000, then instead of debiting, the expense at that point in time, we’re just going to 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 going to 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 going to be credited. So that’s going to go down So obviously that has to go down. And all we’re going to do on the other side is we’re just going to debit the allowance, the allowance has a credit balance, we’re going to 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 million to minus 240. That’s the net value. And now receivables went down and so did the allowance. So therefore, now it’s the 1,000,009 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 9000 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 going to ask well, do people owe us money? Yeah, the trial balances that people 1,000,001 91 Well, who will Have 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 1,000,002. And it went down by nine. If 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 an order by customer so if we look at the customer in this case, we’re going to 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. If we add up all the customers then it adds up to 1,000,001 91.
But 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 afford lie that 31 to any of the actual customers, because it’s just an estimate, we don’t know who’s not going to pay us, we just believe that certain amount of folks aren’t gonna pay us based on prior experience. So now we have G company made a partial payment and went bankrupt is determined that we will not receive the balance. So we’re going to receive 20,000 of cash, and then we’re not going to receive the other 10 so if we look at GE here, we can see that the company owes us 30,000 they’re gonna go bankrupt and then within the bankruptcy, assuming they are paid off who they could, which they paid off us 20 and then they’re not going to 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 going to increase cash, it’s going to 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 Have a debit balance, we’re going to make it go down by crediting it. However, we’re not going to credit it by that 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 credited by 20, then we would show that GE owes us 10. Still, and they don’t, or they’re not going to 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 going to be the uncollectible portion, which we’re going to 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 uncollectible or determined to be uncollectible under the allowance method. We already have this 31,000 we already we already estimated that that 10,000 wasn’t going to be collectible.
We just didn’t know who was not going to 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 journal entry. would look like this we have the debit to cash cash is going up by the 20,000, we’re going to 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 210 equals to 30. The debits equal the credits. Also note that I’ve 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 going to post this to something that’s going to grade you on having the debits on top, you might want to put the 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. Alright, so if we’re going to record that in terms of the trial balance, it would look something like this.
The cash is going to be debited, so it’s going from 100 plus to 20. It’s going to go up or doing the same thing to it. So we’re debiting a debit balance accounts increase in it, the receivable is going to go down so we have the debit here. We are crediting it doing the opposite to it’s bringing the receivable down by the 30 Then that difference is going to go to the allowance. So notice the allowance is a contra account, 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 it was 1,000,001 61. 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 Oh, there’s 1,000,002. Then we had this 9000 that 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, 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 GS accounts. 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 1,000,001 61. That ties out to the general ledger that ties out to the trial balance of that we still have this estimate of 21. That will be not collectible. So the reason it went from 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’ve 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 going to pay you now. And we had totally wrote them off in the past, because we didn’t think we were going to get paid from them. So in this case, remember that the CW company owed us 9000, we determined we’re not going to get paid that we wrote off the 9000 to the allowance account here. So we wrote them off, and now they came in doors that I you know, 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 9000. That’s great. So how would we record that? I’m going to 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 going to do it is that we can think through our transactions and say, well is cash affected? Yeah, we’re going to debit cash because we got cash from the client, and we would normal credit 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 9000 was written off to the allowance account. Why don’t we just debit cash and credit the allowance account, which would cancel out this 9000 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 with 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, we’re going to kind of break the rule of thinking about cash first. In this case, we’re going to say well, let’s reverse what we did last time. As of today, we’re not going to we’re not going to go back in time and do it we’re going to say as of today, we’re going to 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 going to reverse the what we did last time, which was to write off the receivable, we’re going to put the receivable back on the books by debiting, the 9000 to put the receivable back in good standing here, and then we’re going to 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 that the cash is going to the receivable is going to go up by the 9000. And then The allowance is going to be credited by the 9000. Then we’re going to debit the checking account by the nine and credit the receivable by the nine. Note the net difference in the receivable 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 a 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 9000 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 if 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 9000 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 check the audit trail, it would show that there was no payment, we wrote it off. So that audit trail is pretty much the reason why we would do this reversing process instead of just having a simple journal entry, that would just be half as long. Alright, 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 going to pay us we’re going to probably analyze our receivable counts periodically and see that companies will not pay us. And if we look at p company here, we’re going to write them off. So that six seven is going to have to go down and BD company is going to have to go down. That’s the receivable accounts.
So those are the amounts it will go down by, therefore the receivable is going to have to go down by that and that’s going to be a credit and then what are we going to debit once again we’re going to debit the allowance account. So that would look like this we’re going to debit the allowance account for the 14 seven 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 going to debit the receivable and credit the receivable so the receivable is going to go down as 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 1,000,001 61 minus the credit of the allowance that would be the net receivable and then maybe Both went down. Therefore, the new net receivable is now 1,000,001 46 three minus 215. Three. So if we look at the activity then the questions being do people owe us money? Yeah, people always 1,000,001 46 three.
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 nine, it went down by 30. It went back up by nine, it went down by nine, and then we have this 14 went down by that the allowance it 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 8000 here, as well as the BB and T, the six seven, that’s what adds up to this 14 seven, 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 1,000,001 46 three VAT times out to the general ledger that ties out to the trial balance. And we still have this estimate of 15. Three 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 370 8000, 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 gonna 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 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 the 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 low earned that this percentage is uncollectible. Therefore, we can write off the bad debt expense, debit in the expense increase in 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 way is 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 oftentimes you’re going to look at something like an aging account in order to do that. So if we have this at 1,000,001 46, three, if we break that out that 1,000,001 46 three in terms of an accounts receivable aging, which could look something like this, a lot of software’s will have this and stuff like QuickBooks or something can generate those reports. And if we have something that’s 30 days past two, we can have to you know, we might say that 2% is under collectable if it’s between 30 and 60, past to 4%, perhaps 60 and 90 10%, perhaps an 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 then they haven’t gotten back to us, then at some point, we can say that there’s a higher likelihood or probability that, you know, we’re not going to 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 going to say this times this, we would come up with these numbers, and that would say that Okay, oh, the 1,000,001 46 three, we think based on this estimate that 50,004 37 will be uncollectible. Therefore, we still have have 15 300 in the allowance account here. And that’s because we basically overestimated Last time, we thought that we weren’t going to get I think it was 40 at the at the beginning yet was 40 here last time, and and we’re still left with 15. 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 15, three up to the 50, we would do a subtraction problem. And the difference being 35 137 is what we would need in order to bring that amount up to the estimate of 50,000. So if we posted this, so if we took the 15,000 minus the 15, three, we come up with the 35 137. So now if we post this out, then we’re crediting the 35 137 to the allowance so that’s going to take the 15 Three up by 35 137 to the 50,003 47, which matches the 50,003 47 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 35. And that’s going to bring it up to 35. And then if we look at what the effect is on net income, we’re going to say, of this revenue here. 35 of it, we believe is 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 342 863 instead of the 378. So we’re recording the fact we’re representing the fact that of the 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 1,000,001 46 Three however, we believe based on past experience that 50,000 for 37 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 or 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 recording the receivable account that has been collected after being determined to be uncollectible