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Let's talk about the allowance method. The allowance method stands in contrast to the direct write-off method. We'll just call this the direct method. This all lives under bad debts. So when you have bad debts, you can either do the direct write-off method or the allowance method. The allowance method is basically just a method of estimating what bad debts are. And in the last video, we said this method, direct method, doesn't get used that often, so we don't talk too much about it. Now, the allowance method gets used all the time. Under the allowance method, there are two different ways to estimate. One is the income statement method, and unsurprisingly, the other is the balance sheet method.
So I want you to have a full overview of what you're dealing with here. The question is: how do we deal with bad debts? There are two methods to dealing with bad debts, the direct method and the allowance method. Direct doesn't get used that often. Allowance does. When you're using allowance, you're making an estimate. You're saying, "I'm going to somehow, using math, guess what my bad debts are going to be." To do that, you have two methods again. One is the income statement method, and the other is the balance sheet method. Now, under the direct write-off method, what we did was we said we're gonna take a bad debt expense of $500 and then just decrease our accounts receivable for $500.
That was a direct write-off to the accounts receivable account. And we said for a number of reasons, this isn't ideal. So on the allowance side, I wanna introduce another account. It's called the allowance for bad debts. And right off the bat, you get a couple of things out of this account. You see the word allowance. Allowance tells you that we know bad debts are coming. We're going to allow for that. We're going to recognize the fact that bad debts are going to come, and we're gonna store up and basically save up for the case when bad debts come. Bad debts are going to come. But through this allowance, we're going to be ready when they do come.
And unlike the direct write-off method, we're not going to wait for an account to go bad before we recognize our bad debt expense. Under the direct method, we waited until a customer went bankrupt or decided not to pay before we recognized our bad debt expense. Under the allowance method, we're going to take a bad debt expense every single year that is equal to whatever our estimate is. So let me draw this out for you. We've done this before where we said we make a sale and then the customer goes bankrupt. We expected them to pay here, but they didn't, and the period ended right here.
So under the allowance method right here, we're going to recognize some kind of bad debt expense because we know for a fact that less than 100% of what we think we're gonna collect is what we're actually going to collect. We're not so stupid to think that we're gonna collect every single account that we have outstanding. So in order to follow the matching principle and to represent our assets in a conservative manner at the year-end, we're gonna take a bad debt expense so that when this happens, we don't have to go all the way back here and say, "Okay, well, how do we adjust it?"
We say, "No, no, no, no. I already took care of it. I already allowed for that at 12/31." Hence allowance. We are allowing for some portion of these accounts to go bad at the year-end, such that when they do, we don't really have to deal with it because we've already done it. Let me talk about it in terms of a metaphor. Let's say you have some rainy day fund. You have some savings account where you store money because you know that at some point your car's gonna break down or the AC's gonna go out or something's gonna happen that you need to have money on hand for.
So we'll just call this your savings. Now, a time is going to come when you have to take money out. Let's say car breaks down. So when the car repairs come, you're gonna have to take money out. Now, it would make sense, at least in my mind, to put money in every month.
Every month, you should be putting money in to your savings account so that when something bad happens, you can take money out. This becomes essentially a buffer so that when your car breaks down, it's not a disaster and you're not scrambling and it's not an emergency because you have some savings account. Now, ideally, this would never happen. Ideally, your car would never break down, but you're not so stupid to think that your car is going to work 100% of the time. You know that there is some small percentage chance that your car is gonna break down or you're gonna need your savings for some other emergency.
And so this right here, this is the allowance method for bad debts. So you have your allowance for bad debts. This is the account that says, "I know some of those accounts receivable are not going to be collectible." I know that some of those people are not going to pay. Then you're putting in your bad debt expenses. You're filling it up with your bad debt expenses, and this is every period. Whatever the period is you're estimating, you're putting in bad debt expenses. Then when the time comes that somebody doesn't pay, you're taking it out as a write-off. This is when you're doing the write-off. So you're filling up your allowance, and then when someone decides, "I'm not gonna pay," you think, "Man, that's too bad, but I allowed for that.
That's okay." And you're decreasing your allowance for bad debts. This becomes your buffer. Just like in your real life, your savings account is your buffer against emergencies, this becomes your buffer against write-offs. So then the write-off process is completely decoupled from the recognition of bad debts.
So once we can figure out what this is, and this is determined, this is your guess. This is your estimate. This is what we use the balance sheet method and the income statement method to figure out. We're trying to figure out what's our bad debt expense. But once you figure that out, you have your bad debt expense, and you increase it by doing a debit, because it's an expense, and then you have your allowance for bad debts, and you increase that by doing a credit, because allowance for bad debts is a contra asset, and so it is the opposite of an asset.
And assets are increased by debits, and so contra assets or opposite assets would be increased by a credit. So this entry right here is recognizing a bad debt. This is what you do when you are recognizing your bad debt at the end of the period. And this right here, this number, this is our guess. This is our best management guess of, "Heck, I don't know, but I bet it's gonna be around $1,000." That's my best guess for bad debts. And there are two methods to get your best guess. There's your income statement method, and there's your balance sheet method. I'm gonna take a whole 'nother video just to talk about these two methods, because I think it's very important that you understand what they are, how they're different, and how they're the same.