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Assessing the allowance for doubtful accounts; using historical data to evaluate the estimation process.

Article Excerpt
EXECUTIVE SUMMARY

* Aging is the most common technique used to value receivables. However, several other analysis techniques can provide insight regarding the accuracy of prior estimates and the effectiveness of the estimation process.

* Comparing bad debt expense each year to write-offs during that year is one measure of the accuracy of bad debt estimates. Calculating the ratio over multiple periods, rather than a single year, provides the most useful information.

* Comparing the beginning allowance for doubtful accounts to subsequent write-offs determines the adequacy of the existing allowance. Lower ratios indicate the allowance may be too low, while higher ratios may signify the accumulation of excessive allowances.

* The allowance exhaustion rate is the amount of time it takes to write off an allowance. A corporation may be accumulating excessive allowances if it takes several years to exhaust its allowance for doubtful accounts receivable balance.

* Evidence suggests that some companies have great difficulty in estimating collectibility. Accountants potentially benefit by using additional tools that shed light on the accuracy of past estimates.

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Calculating estimates of the collectibility of accounts receivable and auditing those estimates is difficult. This article describes three techniques for assessing allowance for doubtful accounts estimates and complying with Statement on Auditing Standards (SAS) no. 57 and AU section 342, Auditing Accounting Estimates, which suggest auditors compare prior accounting estimates with subsequent results to evaluate the reliability of the process used to develop estimates.

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Accountants have typically relied on accounts receivable aging as the primary tool for evaluating collectibility. Aging allows companies to generate estimates of uncollectible accounts at specific times. However, the technique does not consider the accuracy of past estimates, as mandated by SAS no. 57. An analysis of historical trends can provide useful information about an entity's past accuracy and possible biases in estimating its allowance for doubtful accounts.

TECHNIQUES FOR ANALYZING THE ESTIMATE-GENERATING PROCESS

Exhibit 1 uses three years of data from Dell Inc. to describe three simple techniques for assessing past estimates of the allowance for doubtful accounts. Because the techniques use historical data, they give an indication of the effectiveness of past estimates. After they are described, the techniques are demonstrated using data from three technology companies--Dell, Apple Inc., and Cisco Systems Inc.--that exhibit markedly different historical patterns in the estimation and use of their allowances for doubtful accounts. All data used in this article is available in these companies' filings at sec.gov.

Technique 1: Compare bad debt expense (BDE) to write-offs (WO). Bad debt expense recorded in a specific year implies the necessity for write-offs during that year and subsequent years. While it is unrealistic to expect estimated bad debt expense to perfectly match...

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