Final answer:
The first step in using a balance sheet approach to estimate bad debts is to calculate the desired ending balance in the Allowance for Doubtful Accounts, which is critical for a bank's financial planning and potential net worth estimation.
Step-by-step explanation:
The first step in using a balance sheet approach to estimate bad debts is to calculate the desired ending balance in the Allowance for Doubtful Accounts account. This account represents the estimated amount of accounts receivable that will not be collected. A well-run bank factors in a percentage of loans that will not be repaid into this account. The calculations include loans that borrowers do not repay, and the balance sheet reflects the risk of non-payment. Should loan defaults exceed expectations, as during a recession, the value of the bank's loans and subsequently its assets might decrease significantly, potentially leading to a negative net worth.
The "T" in a T-account separates the assets from the liabilities. For a bank, assets include reserves and loans while liabilities include deposits and others. Net worth is total assets minus total liabilities and is listed under liabilities to balance the T-account. Positive net worth indicates a healthy business, whereas negative net worth indicates potential insolvency.