Hello, I'm Professor Brian Bushee. Welcome to week four of our Coursera course. This week we're going to be taking a look at accounts receivable and inventory, in more detail. This video will start with accounts receivable, and look at that problem that we make sales to customers on account, but not all of them pay us. What do we do to account for this? Well, let's get to it and see what happens. We're going to start our look at accounts receivable with a review of the revenue recognition criteria. So if you remember back in week two, we talked about how revenues recognized when it's both earned, we provide the goods and services. And realized, which means we get paid in cash or something that can be converted to a known amount of cash, which would be accounts receivable. So the accounts receivable, as we know by now, is created when the payment is due from customers after the revenue recognition. One thing that came up at the time is that some of these customers are actually not going to pay us. And so what we'll talk about now 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 aren't going to pay them. But if you're going to grow the business, you have to take some chances on your credit sales. And until somebody figures out a foolproof method to avoid selling to customers that won't pay you in the future, I'm going to keep teaching you how to account for the fact that some of those customers will default on their obligations to you. So there are two methods that we can use to recognize or account for these uncollectible accounts, when we make a sale on account and we don't collect from customer. First method is called the direct write-off method, which says that you just recognize an expense when you realize that you can't collect from the customer. You know, this is what's used for tax reporting. But it's not allowed under GAAP or financial reporting. >> What? How can the accounting for tax reporting 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 review those first week of videos. So financial reporting's what we're doing here. Putting together financial statements for external stakeholders, investors, analysts, creditors, and so forth. The rules for tax reporting are generally different than the rules for your financial statements. We're going to talk later in the course about how to account for those differences, but this is going to be one of many situations where what we do on the financial statements is going to be different from what companies have to do in their tax returns. So the method we're going to use for financial reporting, which is required under GAAP, is called the allowance method. The allowance method is going to force us to recognize bad debt expense for unestimated future uncollectible amounts from all the sales that we made during the period. >> Before you go on, may you please explain why we have to estimate future uncollectible accounts during the same period as the sales? >> Best way to think about this is the matching principle. So a cost of doing business this period, a cost of generating revenue of shipping goods to customers, is that some of them are not going to pay us in the future. So we want to estimate those expected loses now, to match them to the revenue that we're booking this period, so the bad debt expenses, the cost of generating revenue this period. Another way to think about this is when we look at revenue minus expenses, that profit should equal the cash that we're going to collect either now or in the future. And by recognizing that bad debt expense, we reduce the revenue to the amount of cash that we eventually expect to collect from the customers on those sales. In addition to recognizing an expense in 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 going to be a counter asset, so it's going to work just like accumulated depreciation, where we're going to use it to keep track of expected reductions in accounts receivable. Now I'm going to go through examples on this in a little bit, but what that means is what you'll see on the balance sheet is net accounts receivable, which is going to equal gross accounts receivable, the amount of receivables you originally booked when you made the sales, minus this allowance for doubtful accounts. And this is completely analogous to net property, plant, and equipment equals property, plant, and equipment at its original cost, minus accumulated depreciation. Basically, accountants have like four or five tricks and we use them over and over and over again. So counter asset is one of these tricks that we use over and over again. So let's go through an example of how this works. So 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. One of the things that professors often do in coming up with example names is to try to find unisex names that could be either men or women. In the old days, we would have done Chris, Pat, and Tracy. But nowadays, if you go to a playground and you hear Jordan, Dakota, or Peyton, you're just as likely to see a little boy or a little girl come running up. Of course, I do realize what I need to work on are internationally neutral names, so that you're not necessarily picturing little Americans as you are with these names. The way these transactions will look on our balance sheet equation is we'll have $30 of accounts receivable and $30 of sales revenue. So we've got the asset and the stockholder's equity account. But then we need a second ledger, a subsidiary ledger, called the accounts receivable ledger, where we need to keep track of accounts receivable for each and every customer, so that we can know what a customer owes us and then record it when they pay us back. So what we actually see on the balance sheet is this total accounts receivable account, but actually companies are keeping track of little accounts receivable accounts for every customers. So we've got Jordan, Dakota, and Peyton each have accounts receivable of ten, which add up to the 30 that you would see on the balance sheet. Now, we're not going to forget about journal entries as we go through this new material. We're always going to go back to how things are going to be represented in journal entries and in T-accounts. So at the time of sale, you would debit accounts receivable, then increase the asset, credit the sales revenue for 30 or, if you did it for each individual customer, it would be three entries with debits and credits of ten each. Then we're going to look at the accounts receivable related T-accounts. So, we're going to track the actual accounts receivable account, this contra asset allowance for doubtful accounts, because it's contra asset, notice the beginning balance is going to go on the credits side, we'll have a T-account for sales revenue and an account for bad debt expense. >> Why is the allowance called doubtful accounts, while the expense is called bad debts? And like, you can hold them in collectable amounts before. Dude, what is the correct jargon? >> Yeah, thank you for asking that. I'm purposefully using three different names because this is an item where companies use a lot of different names to represent it. You'll hear bad debts, doubtful accounts, uncollectible accounts. In fact, you often never hear bad debt expense, because that sounds really bad. Instead, it's called provision for doubtful accounts, or provision for uncollectible accounts, which sounds much more pleasant, although provision means the exact same thing as an expense. And the way this first entry will affect our T-accounts is the credit sales will increase accounts receivable and increase sales revenue, on the debit side for accounts receivable, on the credit side for sales revenue. Continuing on with the example, at the end of the period, it's time to put together financial statements. And BOC has to estimate what amount of the sales made during the period will not be collected. Their estimate is $10. Now later on, we will talk about how you estimate this amount. But for now, let's just assume this is our best estimate. So what's going to happen is we're going to make an adjusting entry, where we create an allowance for doubtful accounts of ten and we recognize an expense of ten called bad debt expense. So what this is going to do is it's going to reduce our accounts receivable on the balance sheet to 20, net accounts receivable's going to be accounts receivable minus the allowance. And what shows up in the income statement is 30 of revenue minus 10 of bad debt expense. So a net of 20 profit on this, which is what we expect to actually collect from customers. In terms of accounts receivable ledger, we don't do anything because we don't know which of these three people is not going to pay us. And this is the whole reason for creating the allowance account is if we were going to reduce accounts receivable directly, we would also have to reduce one of the individual accounts to get it to balance in our accounts receivable ledger, but well we can't do that because we don't know which of the three are going to not pay us, so we still were the expected losses in this allowance account, until we really find out who is the dead beat, I mean, who is the one that doesn't end up paying us. So the journal entry is we debit bad debt expense, so that expense is going on the income statement of ten. And we credit this contra asset allowance for doubtful accounts. Credit increases the contra asset, and it's going to reduce total assets when we put together the balance sheet. >> Adjusting entries are the ones that 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 I was joking about accountants staying on New Year's Eve to do adjusting in journal entries. They actually have two to four weeks after the end of the period to do their adjusting entries. I mean, accountants are probably the first ones out the door on New Year's Eve day. But, anyway, we do this as an adjusting entry because we only have to get this right when we put together financial statements. So we go ahead and wait til the end of the period, and then estimate either bad debt expense or the allowance based on sales or receivables for the period. In the next video, we're going to look at the different methods for estimating this, and then you'll see why it makes sense to do this as an adjusting entry. Anyway, this will map into our T-accounts by increasing the allowance for doubtful accounts. So there's the credit entry for bad debt expense. And then there's a debit entry to increase our bad debt expense. Continuing now with the example, in the next period, BOC collects the cash from Jordan and Peyton. So we end up increasing cash. They each owed us ten. We increased cash by 20, and we reduced the accounts receivable. In the A/R Ledger, what we're going to do is get rid of Jordan's account, so have a credit to ten, so now the balance if zero. Get rid of Peyton's account, so the credit of ten now has a balance of zero. And that adds up to the credit of 20 overall for our accounts receivable. Obviously, we don't do anything for Dakota because we're still waiting to collect from Dakota. Journal entry here is one you should be familiar with. We collect cash, cash goes up, we go up, cash goes up through debit, and we credit accounts receivable. We reduce the asset through a credit, both for 20. And then in our T-accounts, the cash collections will show up on the credit to accounts receivable, and I had to slip in at the bottom a cash T-account to show the other side, the debit side. I don't have this up here because eventually we're going to use these T-accounts to solve for missing items, and so we really need to focus on the core four, as opposed to just the cash. But I wanted you to see both the debit and the credit. Anyway, continuing on with the example, after 90 days, BOC gives up on collecting from Dakota and decides to write-off the receivable. So, what's going to happen here is, first off all, we're writing off the accounts receivable. We're saying Dakota is not going to pay us. We reduce the accounts receivable with a credit or a negative, so we reduce accounts receivable by ten. And we also get rid of the allowance for doubtful accounts. It's no longer an allowance for doubtful accounts, it is the doubtful account. So we've been storing up this ten, waiting to see who didn't pay us, now that we know it's Dakota, we can get rid of this allowance, we basically use it up. >> 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? >> That's a good question. We don't erase the revenue at this point. We essentially zeroed out that revenue when we recognized bad debt expense, because the bad debt expense was reducing the revenue to get to a profit number, which reflected what we actually expected to collect, in other words anticipating the write off of the uncollectible, which turned out to be Dakota. If we reduce revenue again when the write-off happened, we'd essentially be deducting from revenue twice. So, once we do the bad debt expense during the period of sale, we're taking care of the future write-offs, you don't need to do anything else in terms of revenue or expense when the actual write-off happens. And then if we look at our accounts receivable ledger, we're going to zero out Dakota's account, not because Dakota paid us, but because we've given up on Dakota paying us. So, we reduce the accounts receivable from Dakota to zero. We reduced total accounts receivable, and now everything is zeroed out. Journal entry is we debit allowance for doubtful accounts by ten, that reduces the contra asset, and we credit accounts receivable for ten. So here's where we're actually writing off, writing down the balance in accounts receivable. In our T-accounts, the write-offs will be something that reduces accounts receivable through a credit and reduces the allowance for doubtful accounts through a debit. So if we look at our final totals, we got $20 of cash and $20 of pre-tax income. The accounts receivable, we created 30, but then we either collected cash or wrote them off. We created the allowance for doubtful accounts but then when we found out who didn't pay us, we zeroed that out. We have 30 of revenue, ten of expenses for 20 of pre-tax income. So in the end, the amount of pre-tax income we get matches the cash we actually collect. In our accounts receivable ledger, everything is zeroed out at this point, either people have paid us cash, or we've written off the account. And so, if this is all that happens, you could go ahead and put an ending balance for accounts receivable, ending balance for allowance for doubtful accounts. One more thing that would come in with the sales account, is there's cash sales, in addition to credit sales. Once you have those in there, we have the income statement amount and then the bad debt expense is the only thing that is going to hit this account and that will show up on the income statement. >> What should 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 Dakota if she's going to pay us, even though it makes the accounting a little trickier. So, let's look at what you would do if you recover an account that you had originally written off. So let's take a look at what happens if Dakota later pays us. So after the write-off, Dakota wins the lottery and one of the first things that she or he does is decide to pay us the $10 that he or she owes us. So this would be an unexpected recovery. What we're going to do is first increase accounts receivable. So basically, restore Dakota's accounts receivable, credit allowance for doubtful accounts. Basically restore the allowance because we set that aside thinking that somebody wouldn't pay us, initially we thought it was Dakota, turns out not to be Dakota, so we need to put the allowance back for someone else that might not pay us. >> Wait, this journal entry has created the balance in the allowance account, but like, we do not have any more receivables outstanding. >> Yeah, the problem with this example is we only made three sales and then we were done. In practice, we would be making new sales all the time, new credit sales, we would need new allowance for those credit sales, and by putting this allowance back, we're just saying we, you know, we initially thought it was Dakota, but she paid us back. There's someone else that we've made a sale to subsequently that's not going to pay us. And this allowance will help offset that. Anyway, once we've restored the accounts receivable, then we credit it to eliminate it, and we collect the cash, debit the cash. So, we essentially have to recreate the accounts receivable so that we can collect on it, and then recreate the allowance so that it can be used to another customer that ends up not paying us. So, we've got one more element, really, in our T-accounts, which is we may have recoveries. Recoveries would increase accounts receivable, and increase the allowance for doubtful accounts. And then, of course, we would record the cash collection in this case, where that would reduce accounts receivable and increase our cash. So hopefully that, this example gives you a sense for how all of these different activities related to estimating and recognizing bad debts, flow through the journal entries and T-accounts. And the thing we will need to work on next is estimating the dollar amount for the uncollectible accounts. I keep ending my voice over PowerPoint narration saying the exact thing that I intend to say in the wrap up video. I need to stop that. So at the risk of repeating myself, what we will do next video is see how we estimate this number for bad debt expense each period. I'll see you then. >> See you next video.