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“There students my name is nathan and i m a czech tutor today are gonna gonna be talking about the allowance method. Now the allowance method is the opposite of direct write off method. I discussed in a previous video. The allowance method is a more accurate way of recording bad debts now bad debts is when you expect a customer not to pay you in cash for a previous sale.
Now. The reason. Why allowance method is more accurate is because it conforms to gaap under what they call the matching principle. So the matching principle means that in a period of sale you must match the expense associated with that sale every sale.
There s going to be an expense associated with it right it takes money to make money essentially. So you have to go and record. The expense in the same period as the sale and same with bad debts bad debts is an expense and so you got to make sure you match that expense with the related sales in the same period. So on the left side here.
I went ahead and talked about the allowance method. A little bit so i ll continue on that once again you estimate bad debts in the same period of sales and these are estimates so they don t know exactly what s gonna happen like the direct write off method when they deem that they re not going to be collecting that cash that s when they record it. But under the allowance method. You actually make estimates usually at the beginning of the year to see exactly what you think you re not gonna receive in cash later on so usually they use historical analysis.
And these estimates are a percentage of receivables or a percentage of credit sales. So these companies look to their past history. And see exactly based on historical analysis. You know they suggest about let s say 4 percent.
That they re not going to receive in cash. And that s just based on past history. When customers haven t paid them sometimes they use an aging method where they actually age receivables so the longer the receivables are left unpaid you know the less likely they re gonna receive that in cash. It s the longer the time goes on the less likely.
They re gonna get paid for those sales. So that s another way they can do it they can estimated as a percentage or they can use an aging analysis. So when they estimate these bad debts. They record what they call an allowance account.
This allowance is just basically an estimate. Upfront of what you think that you won t collect during the year. They just create that in advance kind of like as a precautionary measure just to say okay. Most likely we re not going to receive this in cash these sales.
So we re going to create a little allowance account that actually will offset our accounts receivable when i mean offset. It s the opposite. So that s what they call a contra account. So that allowance account.
You actually deduct from your receivables. Because you expect not to receive a portion of those receivables. So you set up that allowance account and you deduct. It from your accounts.
Receivable once again this method does conform to gaap since it adheres to the matching principle and here like i was saying accounts. Receivable minus allowance for doubtful accounts. What they call net realizable value net realizable value means what you expect to receive in cash right you have your receivables and then you have that little allowance account of the estimate of what you expect not to receive in cash you deduct that out and then whatever s left over is what you expect to receive in cash. So this is a very tricky concept a lot of my students have a hard time with it.
But i ve come up with some simple methods to help you remember how it works. So you can easily attack problems on exams. So let s go and take a look at a practice problem. And see how you do so here.
We go on the right side. We have a practice problem on january. 1st. 2015 lifeworks incorporated had a debit balance in their allowance account for 2500.
So at the beginning of the year. They already had a balance in their allowance account. Most likely from a previous year carried forward now during this year. 2015 they had credit sales of 400000.
Based on the company s history. They estimate that about 4 of those sales will be uncollectible. So customers will not pay for about 4. Is what they estimate.
What is the adjusting entry to be made at the end of 2015. So what adjusting entry must be made now this is very tricky so just make sure you listen carefully first step to attack this problem you need to go and focus on what the balance and allowance account was at the beginning of the year and here s i threw a curveball your way this is very important it has a debit balance. So the allowance account the normal balance the positive mounts is credit that s a positive bounce. But they have a debit balance right here.
So why is that well the main reason. Why is what we call write offs. You write off an account you end up debiting allowance for doubtful accounts to remove. It that s what we call a write off now most likely write offs exceeded their estimates that s why they haven t debit balance starting out so we know that credit balance is positive therefore if it s a debit balance in allowance.
It s actually negative. So i ll just go and start over here. We ll do something called like a time line to show you exactly how this works. So we ll start on the left side here for january 1st 2015.
The allowance account has a negative 2500 balance. What i call your beginning allowance negative. 25 so start there now during the. Year they had credit sales of 400000.
And they estimated that 4 of those sales at the end of the year will be uncollectible. So what you re going to do is you re going to move that all the way over to the right you can imagine. This is a little timeline here so over here you re gonna have december. I want to say 31st 2015.
And that s gonna be your ending balance. Essentially and your allowance account so ending allowance and for that number you have to go and calculate it they said. It s four percent of their sales. They expect not to receive so four percent times four hundred thousand let s go ahead and get that okay so they expect about 16000.
They won t will collect all right so you started with a negative 2500 balance at the beginning then you ended with 16000. The question is what is the adjusting entry to be made what must you adjust essentially to get from negative 2500 to 16000 that s what they re asking what is the adjusting entry to be made well you just go ahead and subtract and figure out the number to get from 2500 negative to positive 16000. And if you do that the middle number in between will be eighteen thousand five hundred so basically it takes 18 thousand five hundred to get from negative 2500 to sixteen thousand and that adjusts the entry is also what they call your bad debt expense. So you must record a bad debt expense of eighteen thousand five hundred to get from negative 2500 to sixteen thousand and that s how it works so once again they recorded that expense in the period of the sale.
And that adheres to the mashing principle under gaap. We took our beginning allowance account and to get to our ending allowance account. We just made a bad debt. Expense and that s another way to say.
Adjusting entry. What adjusting entry must be made to get from negative twenty five hundred to sixteen thousand. Now you can also see bad debt expense. I like to tell us to my students you can see it as like a ladder right to get over the bridge or climb the ladder to get from negative twenty five hundred to sixteen thousand.
What must be made and you must have a little bridge of eighteen thousand five hundred to get there hopefully. That was helpful for y all. Today. There.
s actually a lot more concepts. That go into this. Including write offs and reinstatements of accounts. But for this video.
We re just going to talk about the basics of allowance maybe later on i ll record a more advanced video for the allowance method. And my little link is down here. So again. I am.
A czech tutor. So if you want to come visit. Me at this page and send me a message. I can help you one on one maybe you need some homework help or some exam preparation.
Just go and go to this link here. I go. By nathan g. And i d be happy to help you alright once again thanks for listening and i ll see you in the next video.
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