Question

QUESTION: Paraphrase this article into your own words.

Article: Assessing the Allowance for Doubtful Accounts

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.

TECHNIQUES FOR ANALYZING THE ESTIMATE-GENERATING

The techniques use historical data, they give an indication of the effectiveness of past.

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 actual write-offs in a given year, it is reasonable to expect the ratio of bad debt expense to write-offs to be close to 1.0 over an extended period.

Technique 2: Compare beginning allowance for doubtful accounts (BADA) to write-offs (WO)

This ratio is computed each year using the beginning-of-year allowance for doubtful accounts as the numerator and write-offs of accounts receivable recorded during the year as the denominator. The beginning-allowance-to-write-offs ratio indicates how adequately the allowance accommodated subsequent write-offs. Lower ratios suggest the beginning-of-year allowance may not have been large enough to absorb impending write-offs, while inordinately high ratios might indicate the entity was accumulating excessive allowances.

Technique 3: Assess the allowance exhaustion rate

Exhaustion rates indicate the time (expressed in years) taken to use the beginning-of-year allowance in the form of actual write-offs.

Assessing the effectiveness of past estimates provides a potential basis for confidence in future estimates. The techniques illustrated in this article are designed to help with and clarify assessment of an entity’s past success in estimating its allowance for doubtful accounts. While economic circumstances vary, historical trends provide useful information about the process used to form estimates.

Answer 1

There are basically three techniques used by auditors in order to assessing allowance for doubtful accounts estimates. These has been prescribed in  Statement on Auditing Standards (SAS) no. 57 and AU section 342, Auditing Accounting Estimates.

Technique 1 states that we can take the ratio of bad debt expenses to write off during the period to estimate the allowance for doubtful debts. In this case we shall take bad debts actually recorded as a base and estimate the allowance to the reasonable close.

Technique 2: This technique works upon the assumption of allowance for doubtful debts(ADD) in the begining itself. In this approach, management assumed ADD in the begnining itself and than record the actual write off during the year. Ratio is calculated as to Begnining ADD/Actual write offs where high ratio shows that there was higher allowance whereas lower ratio indicates that the allownace was lower.

Technique 3: In this technique, exhaustion rate is used which indicates how much time was taken to exhaust the given allowance by the company in the previos year. Suppose it took 10 months of the financial year to exhaust $ 10 million of the allowance than it will take $ 2 million more in allowance to the total of $ 12 million in the current year.

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