The course builds on my Introduction to Financial Accounting course, which you should complete first. In this course, you will learn how to read, understand, and analyze most of the information provided by companies in their financial statements. These skills will help you make more informed decisions using financial information.
Video 5.1.2: Estimating Uncollectible Accounts
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From the lesson
Week 5: Introduction and Working Capital Assets
Now that we have a solid grasp of the foundations from the Introduction to Financial Accounting course, we are going to work our way around the Balance Sheet to discuss various types of Assets, Liabilities, and Stockholders' Equity (along with their associated Revenues and Expenses) in more detail. We kick off with Accounts Receivable and the problem that some customers that buy goods on credit will not actually pay us. We will look at the computation, disclosure, and analysis of such "Bad Debts". We will also briefly discuss other Accounts Receivable issues such as Factoring and Securitization. Then, we will move on to Inventory. We will discuss how Inventory accounting differs between retail and manufacturing firms. We will see how companies figure out the cost of the inventory they sold, which requires assumptions about cost flows. This discussion will lead us into covering one of the most infamous accounting topics: LIFO.
Meet the Instructors
Brian J BusheeThe Geoffrey T. Boisi Professor
Accounting
Hello, I'm Professor Bryan Meshay, welcome back.
In this video we're going to take a look at some of the different methods that
companies use to estimate the number for the expected bad debts during a period.
We'll also talk about how bad debt expense, and allowances for
doubtful accounts show up on the statement of cash flows.
And we'll talk about some methods that companies use to try to
collect their accounts receivable more quickly.
Let's get started!
There are two basic methods that are used to calculate the amount of
unclockable accounts.
I know, Accounting almost seems like Noah's Ark,
where there has to be two of everything.
But anyway, the first method is called the Percentage-of-sales method.
This method estimates bad debt expense directly.
And the way you calculate bad debt expense is,
you multiply either total sales, or if you have it, credit sales,
by an estimated uncollectable percentage to compute bad debt expense.
So in other words, you take all of your credit sales,
you estimate what percent of those you're never going to collect in cash.
That's going to be your bad debt expense.
You plug it into the T-account, and solve for the ending balance of allowance for
doubtful accounts.
The second method is called the aging-of-accounts-receivable method.
This method estimates the ending balance of the allowance for
doubtful accounts directly.
The way this method works is you multiply the accounts receivable on
the balance sheet.
By estimated uncollectable percentages.
Now it's called an aging method, because the percentages are different based at
how long the accounts receivable are outstanding.
So for example, accounts receivable that are outstanding for less than 30 days will
have a smaller percentage than accounts receivable that have been outstanding for
more than 90 days.
So once you multiply all the accounts receivable by the percent of them you
expect not to collect, it'll give you an ending balance for allowance for
doubtful accounts.
You plug that into your T-account, and
that'll allow you to solve for bad debt expense.
>> Are you just teaching two methods, so
that you will have more questions to ask on the exam?
Which methods do companies actually use in the real world?
>> Yes, if you're an conspiracy theorist, you could assume their are multiple
methods because accounting professors need more material for their exams.
In the real world, companies can do either method.
Or they can do both methods and take an average.
And the reason there are two methods is because you have a balance sheet and
a income statement.
So if you're going to estimate bad debts.
You can either do it based on the balance sheet amount of receivables at
the end of the period, or the income statement amount of credit sales.
Companies will just choose whichever method they think gives them
the most precise estimate.
Let's do an example where we implement both methods for
estimating on collectible accounts.
We're going to go back to our old standby example company, BOC.
And here are their T-accounts for a given quarter.
We'll assume they had credit sales of 75,000,
so that increased their receivables and increased their sales.
We'll assume that they collected 69,500 on cash on those accounts receivables.
So it's reduction to accounts receivable.
It's also an increase to cash.
To save space, I left the cash T-account off the screen.
And during the quarter they had write-offs of 500, so they reduced their
accounts receivable, and they reduced the allowance for doubtful accounts.
Now, all that's missing is, what is the bad debt expense during the quarter?
And then, what's the ending balance and allowance for doubtful accounts.
The first method we're going to use is the percent of sales method.
So BOC had credit sales of $75,000 during the quarter, as we just saw.
They estimate that two percent of the credit sales will be uncollectable.
So, bad dept expense is going to equal the credit sales times this
estimated uncollectable percentage.
So that's 75,000 times 2%, or $1500 of bad debt expense for the quarter.
This method looks easy peasy.
However, how shall we determine the estimated uncollectible percentage?
>> Your absolutely correct that the formula is easy peasy, and the challenge
here is really coming up with the estimated percentage on collectibles.
There's three different factors companies can look at.
One is, what's their experience historically, so
what are their recent experiences with defaults.
Two is what's going on in the industry, so
what are their competitors' experiences with defaults?
And then three, what do they think is going to happen in the future?
This is ultimately a forward looking estimate, so if you think the economy's
going to go into a recession, you would make the percent higher.
If you think you're moving into a boom time, you would make the rate lower.
But in the end, it's a lot more art than science, and companies generally have to
tweak this rate every period, based on changes in their experience, and
changes in what they think is going to happen in the future.
Now that we have bad debt expense, we can calculate the ending balance for
the allowance for doubtful accounts.
So we plug in the 1,500 of bad debt expense.
Add that to the beginning balance, subtract the write-offs and
come up with an ending balance of 2,100 for allowance for doubtful accounts.
Now let's do the same estimate using the aging of accounts receivable method.
So what we're going to do in this case is start with BOCs accounts receivable.
Which are $15,000 at the end of the quarter.
Then we're going to group these accounts receivable by age.
In other words, how long they've been outstanding.
So, of these $15,000, $8,000 have been outstanding less than 30 days.
$4,000 from 31 to 60 days.
$2,000 from 61 to 90 days.
And then 1,000 have been outstanding for over 90 days.
Then BOC estimates an uncollectable percentage for each age group.
And as you'd expect the estimated uncollectable percentage gets bigger,
the longer the receivables have been outstanding without being collected.
Then we're going to compute the necessary allowance for
each age group by taking the balance in the group times the percentage to
get the allowance for that group.
And we just add up all the allowances to get the ending balance, and allowance for
doubtful accounts which would be $19,000.
>> This looks like, like a lot of math.
How do you come up with all of those percentages?
The same way that they get the percentages for the percent of sales method.
Combination of recent experience, industry trends, and their outlook in the future.
And as I mentioned earlier,
companies should use the method where they think they can get the best estimates.
So, do you think you can get the most precise estimates of the percent of sales,
that are going to be.
On collectible, or do you think you can get the best estimates of the percent of
receivables in each agent category that we have collectible?
Based on that assessment, that should determine which method you use.
Now that we've calculated the ending balance, and allowance for
doubtful accounts, we need to calculate the bad debt expense for the quarter.
So we put the Ending Balance in the Allowance T-account.
We've got only one thing missing, that's Bad Debt Expense.
So if we take the Ending Balance plus the Write-offs minus the Beginning Balance,
we end up with $1,300 of Bad Debt Expense.
And that $1,300 will also show up on the Income Statement as Bad Debt Expense.
Well, these methods gave us different answers for bad debt expense.
How can that be?
Bad debts are bad debts.
Should we rejigger the percentages to get the same answer?
>> Yes, bad debts are bad debts.
But unfortunately, they're all going to happen in the future.
So we can't know, with 100% accuracy, what they're going to be.
We got $1500 under the first method, and $1300 under this method.
Which one is correct?
Who knows.
We could split the difference, and go with fourteen hundred.
We could choose the method, where we're more comfortable with our estimate.
But whatever we do,
we're going to be wrong, because we're trying to predict the future.
The key is we make our best estimate today, and
then we adjust our estimates in the future as we learn more from our experience, and
hopefully we'll get better at this over time.
That ends are example looking at the different methods for
computing bad debt expense.
Next I want to talk about how accounts receivable, and
bad debts show up on a statement of cash flows.
Obviously cash collections of account receivable are operating cash flows.
And then the bad debt expense, the write-offs and
the recoveries are all noncash transactions.
Now when I say recoveries are non-cash transactions,
I mean the part where we restore the receivables, and restore the allowance
not the part where actually recover the cash because that's a cash collection.
So anyway, there are two methods for how bad debt expense can show up on
statement of cash flows under the indirect method.
First, you could add back the bad debt expense,
net of these write-offs and recoveries.
And then add or subtract the change in gross accounts receivable.
So the gross accounts receivable again is how much the customers owe us in total.
So the way it would look is we would start with net income.
We would add back net bad debt expense as a non-cash expense.
And then either subtract or add the change in gross accounts receivable depending on
whether it went up or down.
The second method is just add or subtract the change in net accounts receivable, so
that's accounts receivable net of all these noncash amounts.
So here you would start with net income, and then just add or
subtract the change in net accounts receivable again, depending on whether it
went down or went up, and that would get you to cash from operating activities.
Both methods get you to the same place, the only difference is
whether you separately break out these non-cash expenses like bad debt expense.
Or whether you just fold them in with the change in net accounts receivable.
>> Dude, this is o uncool.
Two methods again?
How can anyone like figure this stuff out if you cannot like agree on any methods!
Hey, at least there aren't ten methods.
So what's going to determine which method a company chooses to use,
is how big of a deal their bad debt expense is.
For companies where bad debt expense tends to be fairly important, or
a fairly large number, they'll use the first method, which will allow them to
show up prominently on the statement of cash flows.
But for companies where bad debt expense is really small, it's not a big deal, then
they'll use the second method they'll just lump it in with net accounts receivable.
Save space on the statement of cash flows.
We give companies two methods, so they can choose the one that
best communicates their important information to outside users.
So although the two methods make your life more difficult.
They make things better for companies, investors, and analysts and
anyone else that need to learn things from the financial statements.
The last topic that I want to talk about are the different methods that
companies can use to collect cash from their account receivable more quickly.
The first method is pledging the account receivable as collateral for a loan.
So, instead of waiting for the customers to pay you to get the cash, you could go
out to a bank and borrow money today with those accounts receivable as collateral.
Then you would still have the accounts receivable, and
you would have to collect those receivables so that you could use the cash
to pay the bank loan and the collateral is there cause if you default on the loan,
then the bank would seize the receivables as collateral.
Now in this case the company is taking the risk of collection,
which they may not want to do.
So there's another way that reduces this risk called factoring.
Under factoring what the company would do is sell the accounts receivable to
a bank at a discount, and that discount reflect both an interest charge and
the risk of uncollectibility.
So let's say you had a million dollars in accounts receivable.
You'd have to wait 30 to 90 days to collect that million dollars.
Instead, you could sell those accounts receivable to a bank, for say $950,000.
You get your cash right away, and
you don't have to worry about collecting the receivables.
Now the reason the bank is paying you $950,000 instead of a million.
Is that part of that reflects an implicit interest charge,
because now the bank has to wait to get the money back.
And part of it reflects the risk of the receivables being uncollectable because
the bank is now taking on that risk.
And the longer the term of the receivables, the bigger the discount would
be because there'd be a higher risk of not collecting them.
So for really long term receivables companies will
sometimes do what is called a securitization.
Under securitization, the company sells the accounts receivable to
a separate legal entity called a variable interest entity, that's created for
the sole purpose of securitizing the receivable.
The VIE then borrows money from the investing public,
and uses the proceeds to buy the accounts receivable from the parent.
It's actually just like the first two methods.
Instead of borrowing from a bank.
You're borrowing from anyone in the investing public that wants to
buy a share of the securitized receivable.
>> Excuse me, but what the lamb are you talking about?
What does any of this have to do with the price of fish?
>> It doesn't have anything to do with the price of fish,
is that some kind of New Zealand expression I've never heard of before.
anyway, I realized that securitization is beyond the scope of the course.
I teach it in my second-year elective at Wharton, and it's incredibly complicated.
In fact, I think I had to teach it for
about six years before I fully understood it myself.
But I think it's important to at least touch on,
because I would argue securitization had a pretty prominent role
in causing the financial crisis in 2007, 2008, and 2009.
I also wanted to highlight these ways that companies can
try to get the receivables off their balance sheet and collect cash faster.
And factoring in securitization are certainly big ways to do that.
So maybe if I ever get around to putting my second-year elective out there as
a MOOC, then you can watch 17 hours of me talking about securitization accounting.
Did I just offer to do another mook on securitization accounting?
Ooh, I need to go back and edit that out.
[LAUGH] So we've wrapped up all the different topics about
accounts receivable that I wanted to cover, and so
what we're going to do in the next video is take a look at an example of
a company's disclosures related to accounts receivable,
to see what kind of information we can pull out of those disclosures.
I'll see you next video.
See you next video!
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