4. Income Statement vs Balance Sheet Methods

Let's talk about estimating bad debt expense. I told you in the last video there are two ways to estimate. There's the income statement method, and there's the balance sheet method. And if you've been going to class, you may be a little bit nervous 'cause this seems complicated, and if you haven't been going to class, you should be. But hopefully I can show you a way that I think makes it all make sense and makes it super easy to remember. What we're trying to do here, before I get started, is we're trying to estimate what our bad debt expense is going to be, and I said in the allowance video that allowance for bad debt is a lot like a savings account.

We have this allowance for bad debt, and we're putting bad debt expenses in over and over and over, and then when we have an account that we have to write off, we take it out of the allowance for bad debt, and this becomes our write-off. But the question is: How do we know how much to put in? How do we know what our estimate for bad debts is? And so that's what we're gonna try to figure out here, is how do we estimate our bad debt expenses? So the end goal for both of these methods, the income statement method and the balance sheet method, is to come up with a single number for bad debt expense so that we can write our journal entry, Bad Debt Expense is something, and put it into our Allowance for Bad Debts at something else.

This is what we're trying to figure out. And of course, because it's accounting, we can't just have one way to do it. We have to have these two different ways, and you've gotta learn 'em both. Let's talk about the income statement for a second. So this is the income statement method, but I wanna talk about the actual income statement. The income statement deals with what? It deals with revenues and expenses, right? The balance sheet deals with what? Not the balance sheet method, the actual balance sheet. It deals with assets, liabilities, and we'll just say owner's equities. The income statement therefore deals in what? Temporary accounts.

The balance sheet deals with what? Permanent accounts. If at the end of Year 1 cash is $1,000, at the beginning of Year 2 cash is $1,000, right? They're permanent. It goes over the year end. Now, for something like expenses, if we say at the end of Year 1 expenses are $1,000, well, expenses are not $1,000 at the beginning of Year 2. Year 2 it starts over, right? Year 2 expenses are zero. So the income statement, all of these accounts close, so we call them temporary accounts. And because all the balance sheet accounts stay open, we call them permanent accounts.

Now, I showed you a journal entry that looked like this: Bad debt expense, some amount. Allowance for bad debts, some amount. And we know that this one, bad debt expense, is, well, obviously an expense. And I've told you a couple times, allowance for bad debts is a contra asset, so it has properties of an asset, but it's just the opposite of an asset. So the allowance for bad debt account is a balance sheet permanent account. Obviously, bad debt expense is what? Well, it's an income statement temporary account. Does that make enough sense? Because it's an expense, expenses go on the income statement. Because this one is super similar to an asset, it's just reversed and serves to take away value from assets, it is a balance sheet account and is therefore a permanent account.

So let's just write over on the income statement side, let's write Bad Debt Expense. And over on the balance sheet side, let's write Allowance for Bad Debts. Now I want you to see what we've just done here. We've just solved basically half the problem. So if we say that the income statement method, because it is named after the income statement, the income statement method deals primarily with revenue and expenses, which are temporary accounts. Which means that we're primarily dealing with bad debt expense, because bad debt expense is an expense and it is a temporary account. Then if I said on the balance sheet method, because it's named after the balance sheet, we're gonna be dealing primarily with assets, liabilities, and equities.

These accounts are permanent accounts. Now, of the two accounts involved in the equation to put things into the allowance for bad debts, we have the bad debt expense account and the allowance for bad debts account. Of those two, the one that is permanent is the allowance for bad debt. So on the balance sheet side, on the balance sheet method, we're primarily gonna be dealing with the allowance for bad debt. On the income statement side, on the income statement method, we're primarily gonna be dealing with bad debt expense. And I want you to keep this in mind 'cause we're gonna come back to this, but I wanna show you a problem and show you how all this good stuff makes your life super easy.

Here's the problem that we're gonna deal with. Here's some information up here. Credit sales, $300,000; accounts receivable, $50,000; allowance for bad debts, $1,000 credit. Company estimates 1% of credit sales to be uncollectible. Company estimates 5% of accounts receivable to be uncollectible.

So the question will say something like, "Using the income statement method, figure out the adjusting entry, and using the balance sheet method, figure out the adjusting entry." Now, using all of this nonsense up here, all this stuff that is seemingly irrelevant to you about temporary and permanent and all that, let's see if that actually does help us when we get down here. So using the income statement method, we're trying to figure out what's our bad debt expense. Well, the income statement is all about temporary accounts, right? So let's look at some temporary accounts. Here's one right here, sales. Sales revenue is a temporary account. So if we take sales revenue and we multiply it by this percentage uncollectible, then we're gonna come up with $3,000.

So what we've done is we've taken a temporary account, multiplied it by a percentage, and come up with another temporary account, and that's all there is to it on the income statement side. On the income statement side it's easy, because you're dealing in temporary accounts. So this $3,000 becomes your bad debt expense, and your journal entry looks like this: bad debt expense, 3,000; allowance for bad debts, 3,000. So because they told us in the problem the allowance for bad debt started at $1,000 credit, we're gonna end up with $4,000 in the allowance for bad debt account, and this right here is our bad debt expense, right?

It matches because 3,000, 3,000. So we put in our bad debt expense into the allowance for bad debts, and that's this entry right here. Okay, that was easy enough, so why all the fuss? Well, on the balance sheet side, we're gonna use permanent accounts, right? So on the balance sheet side, we can't use sales, because sales is temporary. We can use this accounts receivable. So if we say $50,000, then we have to find our accounts receivable percentage, so make sure you're using the right percentage. Company estimates 5% of accounts receivable to be uncollectible. Ugh. Okay, 5%. So if we multiply it by 5%, we're gonna end up with $2,500.

Now, before you write down $2,500 as your bad debt expense, you need to stop and think, because if you did $2,500, "Ah, yeah, that's my bad debt expense," you'll totally get this wrong, because that is a 100% incorrect answer. You cannot take a permanent account in accounts receivable, accounts receivable's permanent, multiply it by some percentage, and come up with a temporary account. You just can't do it. That's not possible. You end up with another permanent account. So what's the problem? The problem is bad debt expense is a temporary account, so what in the world did you just come up with?

You came up with a permanent account, and that permanent account is the only other account that we're dealing with. It's the allowance for bad debts. So what you did was you said allowance for bad debts starts at $1,000, based on the problem, starts at $1,000. Then you do all your magic up here and you come up with the ending balance, which is $2,500. Then all you have to do is solve for the missing amount, and in this case, the missing amount is $1,500. So now I pose the question to you, how do things end up in the allowance for bad debt account?

Didn't we say it's something like a savings account? Didn't we say we put bad debt expenses into the allowance for bad debt account? So then this must be our bad debt expense. The adjustment is the bad debt expense.

In the same way that right here we figured out the bad debt expense and then put it into the allowance by doing it down here, over here we figured out the ending allowance and then backed our way out and said, "Oh, well, this must be the amount for bad debt expense." That's why it's important to understand that under the income statement method, you're using a temporary account to get to a temporary account. Under the balance sheet method, you're using a permanent account to get to a permanent account. So when you see a problem like this and it says credit sales or something, accounts receivable or something, use whatever method.

Well, if the method is the income statement, you are dealing strictly and solely with temporary accounts. You take a sales account, which is temporary, and you end up with an expense account, which is temporary, and at that point, you're done, because this is the adjusting entry.

Under the balance sheet method, you take the ending value of a permanent account and you come up with the ending value of a permanent account, which is your allowance for bad debts. Then you have one more step. Because you took the ending value of accounts receivable, you ended up with the ending value of allowance for bad debt, and so then you just have to fill in the gap and say, the difference here, the way that I get from $1,000 to $2,500, is by adding $1,500. And we know that the journal entry always looks like this. You put a bad debt expense in, and this is the journal entry right here.

And so if I figured out half of it by saying credit allowance for bad debt, 1,500, that's this half, and we know that the matching half is the bad debt expense. So when you see it on your test, think income statement is temporary. Sales is temporary. Bad debt expense is temporary. Balance sheet is permanent. Accounts receivable is permanent. Allowance for bad debts is permanent. Those all go together.