Sales Method or Income Approach for Bad Debts Expense (Financial Accounting Tutorial #43) SPEAKER: Hopefully, you were able to watch the 12-minute video of Bad Debts Expense. I know it was kind of long, but it was a good introduction to this topic. And of course, we needed to cover that content to get into the percentage of sales method, which we're covering in this video; and the percentage of receivables method, which will be covered in the next presentation. So the percentage of sales method, sometimes called the income statement approach or the income statement method, because, of course, sales shows up on the income statement. So before we begin talking about the example and calculating bad debts expense and writing out that adjustment, I thought we would go through some rules that we'd cover really quickly. Rules are usually a good start to a video. They kind of help you with a step-by-step plan to perform this percentage of sales method. So first off, the first one states, you want to record a T account for Allowance for Doubtful Accounts [INAUDIBLE] T account of. Write Allowance for Doubtful Accounts at the top. You want to abbreviate it. You don't want to write that all out, waste all your time on a test or quiz. The second one, of course, the adjustment to record bad debts is always debit bad expense and credit AFDA. And that's because expenses, in general, to increase them, we always debit them. Contrast the accounts. To increase the, we always credit them. And of course, the adjustment is the estimate of the uncollectibles for the receivables. And the third is that only journalize the adjustment because sometimes we have a beginning balance of Allowance for Doubtful Accounts. Sometimes we have a-- we'll have the adjustment, of course, and we'll have an ending. And sometimes we'll have a write-off and then a recovery of a receivable. But you only want to record the adjustment for the estimate when it asks you to record the bad debts expense for the percentage of sales method. And you want to record this, which is the debit bad debt expense and the credit AFDA when you're recording that estimates for the revenues or the sales that you think will become uncollectible. And finally, before this, find the ending Allowance for Doubtful Accounts for the balance sheet. And that's, of course, we need that number for the balance sheet, because what happens is when we have accounts receivables, which, let's say, the balance is $2 million, we'll need to know the Allowance for Doubtful Accounts ending balance. Because if we don't know that, we're not going to be able to figure out the net realizable value for receivables. So let's say it's $60,000. This way, we'll be able to figure out the net realizable value for our accounts receivable since this is only gross receivables up here. So that's going to be $1,940,000, which is the net realizable value or the net receivables. I was trying to say there. So we're going to close this up. Try to remember the rules as we go through this question. And I'll bring it up here. We have gross receivables on the left-- $1 million sells, $2 million net sales, $1.8 million Allowance for Doubtful Accounts. Ending for 2011 is $4,000. And I should say that is a credit balance. And we're in the year 2012. First thing you want to do, throw up that Allowance for Doubtful Accounts, T accounts. And remember that the ending of 2011, same thing as the beginning of 2012. And we'll just write that right in here because that is the beginning balance, because we're writing our T accounts for the 2012 year. Now, we need to do the percentage of sales method. So we're going to take the percentage, which I'm going to give you, which I'll usually give you on a test or quiz. We'll say 2% are uncollectible. And you're going to multiply this by these sales, of course. But which one are you going to use? Aye you may use net sales, or are you going to use sales? What you're going to use is the net sales. And that's because, if you think about it, net sales takes into account any returns or any discounts. So you're only writing 2%, uncollectible, of whatever sales are left. Because of the sales up here, this is gross sales. And it doesn't take into account any return. So, think about it-- if you were to multiply 2% by the total sales, some of these might be returns. And can you really say a return is uncollectible because the person got their cash back for the return? And therefore, they don't owe you any money, so they can't really not pay you because they don't owe you any money. So, remember, it's always net sales that you want to multiply the percentage by. So we'll take the 2%, multiply it by $1.8 million, and it's going to be $36,000. I already have it up there because I forgot to turn on my mic the last time I actually ran through this presentation. So $36,00 is going to be your bad debt expense. And we'll have that added to Allowance for Doubtful Accounts. And that's because, of course, bad debts expense, the adjustments, you're always going to have the same number for bad debt expense and Allowance for Doubtful Accounts for the adjustment, because it has to balance because of the double entry system, of course. So the adjustment is for $36,000, which I have included right there. So if they ask you for the adjustment for the estimate of uncollectibles, that's what you'll write right there. And of course, the ending balance is $4,000 plus $36,000 because they're both credits. You'll end with $40,000 as your end. And what you need to do now finally is look at your gross accounts receivables because we'll usually say prepare the receivables part of your balance sheet. So you'll say, accounts receivables is $1 million. And that you'll write your contra account right underneath it because, of course, contra accounts always stick next to the accounts that they apply to. You'll write $40,000 there. And you will have $960,000 as your net realizable value for your receivables. And then you're done. You have your net realizable value for your receivables. You have your amounts for Allowance for Doubtful Accounts and your adjustment if they ask you for any of those three things. And before we end this tutorial, I just wanted to say, sometimes we'll see in your book that they say the sales method is the approach that does the best job of demonstrating the matching principle. And the reason why is because they're matching the bad debts expense directly with the sales because they're multiplying the estimated bad debts expense by these sales. So of course, you're doing the best job with this method by matching expenses with the revenues earned in the period, which is exactly the definition of the matching principle, which is why this method does the best job of demonstrating the matching principle. And we'll see what the receivables method does the best job of doing, because each of them has an advantage. And we'll see that in the next video, of course. So I'm done for this tutorial. I'll see you guys in the next one. Hopefully, you understood everything. Make sure to subscribe and watch the next one. If you have any questions regarding accounting or any of the material within our video, you can tweet us at @Notepirate. You can like us on Facebook to receive updates or to share any quick [INAUDIBLE] about how videos might have helped. And like always, thanks for watching us on YouTube.