Hello, I'm professor Brian Bushee. Welcome back. One more video looking at accounts receivable, here we're going to look at where we would pull information out of financial statement disclosures in order to calculate some key information that's not otherwise disclosed. So let's get to work. For an example of an accounts receivable disclosure we're going to look at TK incorporated which sells coin wrappers to the banking industry. In case you're wondering, this is not a real company. What I decided to do for this class was disguise all of the companies, change the names, make up different businesses, just so they don't get in trouble for calling out a company on these videos. So anyway, TK Incorporated in selling coin wrappers to the banking industry. Their sales for the year ended December 31, 2008 were $149,270. That's in thousands. That's $149 million. We're going to use excerpts from the balance sheet and statement of cash flows to answer the following questions. First, what were writes-offs of accounts receivable in 2008? What were cash collections from customers in 2008? Both of those things are handy to know, but you often can't find them very easily in the disclosure. So we're going to actually calculate them using the other information that were given and then the last question is by how much did it changed in the estimated uncollectable percentage affect their bad debt expense in 2008? Here's the operating section of the statement of cash flows for TK Incorporated. And you can see 3 years, 2008, 2007, 2006, net income and cash from operations both dropped substantially in 2008. >> Wow. It looks like Hall TK had an awful year in 2008. Weren't banks buying coin wrappers that year? >> Yeah, it does look like old TK did have a bad year in 2008. And I'm pretty sure that most banks weren't using their government bail out money that year to buy new coin wrappers. Which is why TK was struggling so much. So one quick thing I want to point out on the statement of cash flows before we move on is the big negative number for accounts receivable in 2008 which is one of the big reasons they had negative cash flows. Basically TK was making sales, mostly sales were on account. They weren't collecting all of the cash. The account receivables growing and that's like a use of cash. Basically you're booking sales revenue but you're not getting the cash. Big upward trend in how much receivables have been growing over these three years. Here is the Current Asset section of the Balance Sheet for TK Incorporated. And of course, the thing we're focusing on here is accounts receivable. So the disclosure you see here is net of allowances and it gives you the 2 allowance numbers, 1021 in 2008 and 220 in 2007 and as you can see the allowance for doubtful accounts went up substantially in 2008. So the first question we're going to answer is, what were write-offs of accounts receivable in 2008? So what we're going to do over here on the right is bringing our allowance for doubtful accounts, T account, contra assets, so it has a balance on the credit side. The beginning balance is 220, which is what the allowance was at the beginning of 2008, any the balance is 1021. Which was the allowance was at the end of 2008, right now we have 2 unknowns, we don't know write-offs and we don't know bad debt expense if we can find bad debt expense then we can calculate write-offs. If we bring back that statement of cash flows, one of the line items on the statement of cash flows was provision for doubtful accounts. It's a non-cash expense, so it reduces net income. And then, we add it back on the cash flow statement in this case so that we can see it was 1,558. So we can fill in that 1,558 on the credit side. This is what increases allowance for doubtful accounts. There's only one thing missing, and that's write-offs. So we can do is plug and count plug for the missing answer and calculate what the write-offs were, so if we take 220 +1558- the any balance of 1021, we come up with write-offs 757. >> I believed you're mistaken, if there were any recoveries you would need to also include them in the T account. These might have to really snitch recoveries. >> Good catch. We would also have recoveries flowing through this T account, so if there were any recoveries of prior write-offs, then really what we're calculating here is write-offs, net of recoveries. Good job. Next, were going to calculate what were cash collections from customers in 2008. So I've got the accounts receivable, T account over here on the right, and when we first introduced the disclosure example, I said that sales for the year were 149,270. Of course, we could have found that from the income statement. I didn't need to give it to you but it was easier to distribute the numbers than to show you the income statement. So we fill the sales in on the debit side because of course sales increase accounts receivable. Next thing we need to figure out is the beginning balance of accounts receivable. Now, it's not the 7,826 that you see on the balance sheet for 2007, because that's net of allowances. So to get the beginning balance in gross accounts receivable, we need to add 7,826 plus the allowance of 220 to get 8,046 which is the beginning balance. Need to do the same thing for the ending balance, the 12, 930 that you see on the balance sheet is the net amount, we need to add the allowance of 1021 to get 13, 951 which should be our earning balance and gross account receivable. And last, we also know what the write-offs of accounts receivable were because we calculated that on the last slide, so write-offs of accounts receivable were 757 once we plugged that in on the credit side all that's missing is the cash collections from costumers. And so, which is the matter of being out with the plug is that makes this balance so if we take 8,046 the beginning balance plus sales minus right offs of 757 minus the ending balance of 13,951 we end up with collections of 142,608. Now, notice, the difference between the sales and the collections is 6,662. Where we've seen that number before is that was the change in receivables on the cash flow statement. So that 6,662 was the increase in gross receivable, the sales minus the collection. >> That seems like a lot of work to get cash collections. Don't companies just disclose this number somewhere in the financial statements? >> Actually no, most companies don't explicitly disclose the amount of cash collected from customers and the only way to figure that out, is to work through the T accounts. Fill in what you know and then plug for what's missing which will probably be cash collection customers. >> Pardon me, before you go on, may you please explain why you can use total sales and not credit sales to do this calculation? >> Yeah, dude, you had void credit sales in the RT account in an earlier slide >> Okay, I'm going to do a quick digression to show you that total sales is actually the numbers that will get us what we need in this case. So let's go to digression. This is the mega slide that we had a couple videos ago, where we showed how all the transactions flow through accounts receivable, allowance, sales and bad debt. And yes, within sales, we did have credit and cash sales separate. So let's look at an example to get rid of the allowance and the bad debt and just focus on collecting cash and receivables. And let's just, to make it easy, say write-offs from recoveries are 0, so we won't even worry about those. They could be non zero and we would get the same results, I guess you could check that later if you wanted to. We're going to add a beginning and ending balance of 100 for the beginning balance, 200 for the ending balance. We're going to say cash sales are 500, and credit sales are going to be 1,000. So total sales are 1,500. Well, now that we've assumed write-offs and recoveries are zero, the only thing missing in the accounts receivable T account is cash collections on accounts receivable. Which is going to be 900. So 100 plus a 1,000, minus the ending balance of 200, gives us cash collections of 900. So how much cash should we collect from customers in total? We get 900 collecting in accounts receivable, 500 as cash sales, a total of $1,400 cash collection from customers. Now, here's the problem when you look at financial statements. Financial statements don't give you cash collection from customers and they don't give you cash sales. So there's no way that we could actually do this from a financial statement because there's no disclosure of cash versus credit sales. But it doesn't matter. We can do it with just sales. So now let's redo the example. Start with the same beginning and ending balance. Write-offs and recoveries are 0. And we're just going to use total sales this time, so carrying on the example, total sales were 1,500 before. Remember, they were 1,000 credit and 500 cash for a total of 1,500. We plug that 1,500 of total sales into the accounts receivable T-account on the debit side. Now, we can solve for cash collections. 100 plus 1,500 is 1,600 minus the ending balance of 200 gives us cash collections of 1,400, which is identical to what we had before. So essentially what happens in this case is any cash sales show up on the debit side of the accounts receivable, and then they're also going to show up on the credit side as the cash collection. So by using total sales in accounts T-accounts, we're going to naturally get cash collections due to cash sales plus cash collections due to collections on accounts receivable from the credit sales. So it actually become easier when you go to finance statements, you can plug in total sales and then you get total cash collected from customers. Now let's get back to the disclosure example. Last thing were going to do with the disclosure is to uncover the effect of the change and bad that expands due to a change in the estimated percent on collectible. So to do this, first, we're going to compute the percent of gross accounts receivable that expected to be on collectible in the prior year. So we take the net account receivable on the balance sheet, add back the allowance to get the gross, we did that couple of slides ago. Then, we take the allowance divided by the gross to get the percent on collectible. Now, before the virtual students you've asked question, I know this wasn't one of the two methods we learned. One of the methods we learned were the percentage sales method. But to figured out that percentage we need credit sales. We learned the aging of account sale method to that we needed to know a breakdown of receivables by age. As users financial statements, we often don't have those piece of information. So as a quick and dirty approach to get the percent uncollectible, I like to take the allowance divided by the gross accounts receivable. So for instance, at the end of 2008, we have 13,951 of gross accounts receivable. What percent of those do we expect not to collect, 7.3% or 1,021. Now, what we're going to do is apply the percentage from the prior year, 2.7%, to the current year balance and gross accounts receivable to get the expected balance. So this calculation basically says, let's say that TK did not increase their percent from 2.7 to 7.3, but instead kept it at 2.7, if they had, they're allowed to be 2.7% of 13,951 or 377. So that's the expected allowance if they kept last year's rate. Then, as a final step, we just take the difference between those two. And it tells us how much bad debt expense increased, so we do to increasing the percent of uncollectibles, so by increasing assumption of uncollectible percent from 2.7 to 7.3, it add it 644 to the Bad Debt Expense. Now, notice the allowance is total went up by 800 so a lot of the increase in the allowance was, not do to the growth and accounts receivable, but rather do to this increased assumption for the percent of uncollectibles. >> Not math, dude, but when would we like ever have to do this calculation? >> If I was concerned that a company was manipulating it's earning to try to meet an annals forecast or some kind of earnings target, this will be one of the first things I would look at. Because if this change percentage went the other way, if it went down, what that would do is it would reduce bad debt expense and increase net income. So I always tend to look at this if I'm concerned about earnings management and I think what I'll do is let's look at how a rate decrease would effect bad debt expense by calculating 2007. So let's quickly run this back the other way. What if we were trying to figure out how 2007 was affected by having what may have been an abnormally low expected percent of uncollectible? So maybe what happened is TK should have increased their percent sooner but kept it lower just to try avoid signaling the bad news. So we could do here is we could calculate what the allowance would have been at 7.3% so we take 7.3% times 8,046 and we come up with 587. And then, what we can see in the last step is that basically by using the lower rate of 2.7%, TK was able to record 376,000 of last bad data expense. So if you believe a company is artificially keeping it's bad data expense or keeping it's percent of uncollectibles to low, to try to keep its bad debt expense lower and maybe increase its net income, we can sort of estimate what that effect might have been here. And by not increasing their percent of uncollectibles from 2.7 to 7.3 a year earlier, it save them expenses of 367. Now, of course, it could also be that the economy changed between the 2 years so this always isn't going to be a definite indicator of manipulation but it's a piece of information to have and if you think the economy in the banking industry, the demand for coin wrappers was bad in 2007 then maybe the 2.7 was artificially low. So anyway you can always back out this percent on uncollectibles and try to redo what the bad debt expense would have been, had they not changed there assumption for the percent of uncollectibles, and that's going to wrap up our look at what we can pull out of an account receivable disclosure. And that wraps up our look at what we can pull out of an accounts receivable disclosure. I just said that, didn't I? Anyway, this is the last video on accounts receivable. Join me next video as we start our dive into inventory. I'll see you then. >> See you next video.
