1. A/R and Bad Debts Introduction

Let's talk about accounts receivable. Now, hopefully you'll remember that whenever we make a sale, but we don't get paid right away, we put it into something called accounts receivable. And then when we get paid cash, we increase our cash and take it right back out of accounts receivable. And if you'll notice, these two cancel each other out. So what we're left with is just cash and revenue. Now, accounts receivable wouldn't exist if time didn't exist, right? So we make a sale, and then later we get paid.

So when we make the sale, we increase our accounts receivable, and when we get paid, we decrease our accounts receivable. If we made the sale and got paid at the same time, accounts receivable wouldn't be touched at all. So the issue that we're trying to solve with accounts receivable is an offset in time from the time we made the sale and the time that the person actually paid. And so what that leads us to is this problem: what happens when the period ends, let's say 12/31, and then the time to get paid rolls around and the person doesn't pay? The person goes bankrupt, let's say.

And this is what we call an uncollectible account. We put money into this accounts receivable bucket. We said, "Okay, somebody bought a $500 thing, but they're not able to pay or whatever, not going to pay right now." But we expect at some point to take that money out of accounts receivable because we're gonna get paid. What happens if this account becomes uncollectible? What happens if that person disappears or goes out of business? Do we just leave that $500 in this bucket? Do we just leave it in there until when? Until the end of time? Well, that doesn't make a lot of sense, because you'll remember that accounts receivable is an asset.

Those are accounts that we're hoping to receive. So we can't be putting that $500, assuming that that person's never gonna pay us, we can't put that $500 on our balance sheet because that's not really fair. That's not right. We know that that one's not an asset. We know we're never gonna collect it. And by its very nature, it's not a receivable if we know we're not able to receive it. So this leaves us with the conundrum, right? We put $500 or $1,000, whatever it is, we put $500 in, then we're never gonna be able to get that money out.

How do we represent, when we do our financial statements at 12/31, how do we represent this $500? Because to be conservative, we have to estimate our assets conservatively. But we don't know until this time comes that this $500 is no good. Right? If we're standing at this point in time, we can't see the future and realize that person's never gonna pay us. What we see is we look in the past and say, "Okay, we're owed $500. I'm gonna represent that with $500." So we're left kind of in a bind. We want to represent our assets conservatively, but we also have no way of knowing which accounts are gonna go bad.

And so the answer is, as always, we make it up. When I say make it up, I mean we estimate. So this leads us to the concept of bad debts. When you have a bad debt, it's an account receivable that you now realize, I'm not going to be able to collect. A bad debt is the same thing as an uncollectible account or an uncollectible receivable, whatever you wanna call it. I like bad debts because it makes sense on like a gut level. The debt is bad, and you're just not gonna get it. It's no good. You made a bad call. And these bad debts, we know that these are gonna happen.

We know that bad debts exist, and it's basically just a cost of doing business. And so companies know if I'm gonna offer accounts, if I'm gonna say, "You can have it now, pay me later," some percentage of those are gonna be bad, and they just write that off as, well, that's the cost of doing business. And management assumes we're gonna make more by offering this extended payment time than we're gonna lose on bad debts. And this bad debts, this stuff right here, this allows us to represent our accounts receivable in a conservative way. So we say accounts receivable is the top line number.

That's if everyone paid, this is how much we would get. Then we take out our estimate, and we'll talk all about this. This is most of the chapter, how to estimate. So we take out our estimate of what we think we're not gonna get paid. And what's left is something called the net realizable value.

This is the net amount that we think we'll be able to realize. And it's typically something like 97%, 98% of accounts receivable. It really just depends. It's less than accounts receivable, but it's not so much less than accounts receivable. And this estimate right here, this is a contra account. The only reason that this estimate exists is to decrease the value of accounts receivable so that we can represent accounts receivable in a conservative fashion on our balance sheet. So on the balance sheet, you'll see assets, bunch of stuff, then you'll see accounts receivable, less, it's called allowance for bad debts. This is our estimate.

And then you'll see net realizable value of accounts receivable. So the only reason this estimate account exists is to detract from or take away from the value of accounts receivable, which is the definition, the very definition of a contra account. Its only purpose for existing is to decrease the value of another account. We're not gonna spend too much more time here because like I said, the majority of the chapter is spent here learning how to estimate accurately, or as accurately as we can, what the bad debts are going to be. But the key takeaway here is representing your accounts receivable in a conservative fashion by using the net realizable value and understanding that this estimate account, once we finally figure out how to actually do that, that's gonna be a contra account.