 In this discussion, we will discuss the discussion question of compare and contrast the methods commonly used to calculate bad debt and allowance for doubtful accounts. When looking at bad debt and the allowance for doubtful accounts, the first question we're going to have to ask is what are these things and what does this relate to? What problem are we trying to solve? Why would we want to calculate bad debt expense and the allowance for doubtful accounts? And those two things have to do with accounts receivable. So the accounts receivable is going to be something that represents something owed to us from customers, typically from past sales. It's an asset. It's a current asset and typically it's going to be, it could be overstated. That's the problem with it because it could be a fact that we got people owe us money and we're never going to get paid on it. That's always a risk we have of doing business. What we want to be able to do is tell the readers of the financial statements, one, how much people owe us, and then two, if we can tell them how much of that is owed to us we believe is uncollectable, that would be a fair way to report the financial statements. And that's what we call the allowance for doubtful accounts. That's what we use the allowance for doubtful accounts for. So if we see something that says allowance for doubtful accounts, that means that we're using the allowance method and not the direct write off method, which is a method that doesn't really do that estimate. It waits until the time period that we're not going to collect to record the bad debt. So here we're going to assume that we're talking about the allowance for doubtful accounts when calculate both bad debt and the allowance for doubtful accounts. So then how do we calculate the allowance for doubtful accounts? There's two methods we could use to calculate that. The way I see it, and the way it makes intuitive sense to me, and I think a lot of people that I've talked to on it, usually I think of the accounts receivable and the problem with the accounts receivable more than I think of the income statement and the problem with revenue on the income statement, meaning I typically think of, well, accounts receivable could be overstated. How could we fix that problem? And if you think of that, you're thinking about the balance sheet side of things and you're probably going to take a balance sheet approach to the problem. But as you fix the balance sheet, the income statement also becomes fixed because the other side of the journal entry you will make will be to the income statement. So if you better match up or if you better make the more accurate the balance sheet, typically you could be making the income statement more accurate. So for example, the percentage of accounts receivable method would be in some way to look at the accounts receivable, possibly by looking at an aging account, by listing the accounts out by how old they are, and then determining by industry standards in past experience how much you think is it going to be uncollectible, meaning you might take some percentage of the accounts that are past due by 30 days, some percentage of the accounts that are past due by 30 to 60 days, some percentage of the accounts probably a higher percent as they become more past due from 60 to 90 in over 90. And that would be one way to try to estimate you say, well, the older something is, the more likely we're not going to get collected on it at all because we've tried to collect it for 90 days. So if we've been trying to collect on it for 90 days and we haven't got it yet, then it could be very more likely that we're not going to get paid on that. And then we can see, OK, well, then how much of the receivables do we think are going to be uncollectible? And then we'll make the allowance for doubtful accounts match what we believe is uncollectible based on that estimate. When we do that, however, we won't be reducing accounts receivable because we don't know who exactly is not going to pay us. We can't write down any individual account. Say this customer is not going to pay us. All we have is an estimate that we believe based on this timing estimate, not based on who the customers are of how much we think is not going to be collectible. Therefore, we will make this other account, this current asset account, but a contra account, an asset account that has a credit balance rather than a normal debit balance, which will then have this amount that we believe is uncollectible. So then we'll have the accounts receivable, what we believe people owe us, what people owe us is not really an estimate, minus the allowance for doubtful accounts, which is what we believe is uncollectible, giving us the net receivables. Now that makes the balance sheet pretty good there. Now we show the reader how much is owed to us and how much we think is uncollectible and the net. But the income statement also gets worked out too because the journal entry is going to be a credit to allowance for doubtful accounts and a credit to and a debit to what we call bad debt expense, the income statement side, reducing net income, which solves in some ways, if done well, if the income statement side, meaning the revenue we recorded is too high because if we recorded revenue for something that we're not going to collect on, then it's overstated. And so if we record an expense related to it, bad debt expense, that will reduce it. Now the other method focuses on the income statement more. We can use a percentage of sales method, which focuses more on the income statement, and then the balance sheet will kind of fix itself if we use that method. So if we're more concerned, if our focus is more on the income statement and solving the matching problem on the income statement, the revenue and the related expenses, then the percentage of sales method makes more sense, meaning if we frame the problem more of a problem on the income statement side, which is that the revenue is overstated because we recorded revenue for sales for which we may not get paid on in the future and therefore should be reducing net income in some way with bad debt during this time period, then we can use the sales method instead of the percentage of receivables method, meaning we can look at the sales we made on account this time period, the sales we made for accounts receivable, look at past history or industry standards to see how much of those sales typically become uncollectible and then make a journal entry, the same journal entry, debiting bad debt expense, which would reduce net income, expenses reducing the net income, this time period. So we're recording bad debt expense related to this period's sales, not related to sales that happened in the prior periods as would happen under the direct write-off method, a non-generally accepted accounting principle method. We, in this case, matching the amount we think is uncollectible with the revenue earned in the same time period. And then the credit's going to, once again, allowance for doubtful accounts, which will make the balance sheet side more accurate, hopefully, but by focusing on the income statement side. Now, these two methods typically won't end up with the same exact answers and one will focus more on making the balance sheet correct and one will focus more on making the income statement correct. So it kind of depends on where our focus is as to which method will be preferable. Typically, well, they're both estimates and they're typically not going to come out with the same number and there could be distortions from period to period depending on the method we use. What we typically do want, however, is to use some consistency with the methods over time. If we choose one method, in other words, we should probably be fairly consistent with that method and conform to the consistency standard.