Doubtful account

Doubtful account
See also

Doubtful accounts are used to present the estimated amount of accounts receivable that is expected to become uncollectible in the future. Assessment of the allowance for doubtful accounts has a direct impact on income, and therefore proves to be of high importance for companies which use the reserve method for bad debts accounting[1].

Historical background

The need for estimating doubtful accounts allowance is connected with the commercial lending development. Low availability of cash assets made the companies ship their products without upfront payment in order to increase revenues. As a consequence, bad debts started to occur. Bankers were the first who came up with the idea of measuring the allowance for doubtful debts. The concept started by Florentine Bank Medici was subsequently adopted by other countries[2].

Estimating the allowance for bad debts

According to international financial reporting standards, accounts receivables should be considered a financial asset and therefore they should be subject to impairment tests resulting in a comparison of the asset's carrying value and its probable recoverable amount. The allowance deducts the asset's carrying amount to its likely recoverable amount. Organizations are obligated to show the bad debts allowance if the impairment test proves that allowance is material[3].

Doubtful accounts allowance should be assessed based on operational data as well as the following factors[4]:

  • possibility that the debt is recoverable,
  • past debts repayment dates,
  • probability of repayment based on the client data.

Evaluation of the estimation process

Estimating bad debt allowance is a process which requires making a decision based on multiple factors. Audit of the estimated values is difficult. Some of the audit techniques use historical trend analysis to measure estimation accuracy. Three of them are described below[5]:

  1. Comparing write-offs to bad debt expense. If a bad debt expense occurred during the year, it is necessary to proceed with a write-off within that year and subsequent ones. Estimated bad debt is not likely to match the write-off exactly, however, the ratio of these two is expected to be close to 1.0. Significantly lower ratios for multiple years may imply underestimating the impact of doubtful accounts. Substantially higher ratios may suggest that excessive allowance might have been accumulated.
  2. Comparing write-offs to beginning allowance. The ratio of beginning allowance for doubtful accounts to write-offs is calculated yearly using the allowance at the beginning of the year as the numerator and accounts receivable write-offs as the denominator. This ratio is also called the beginning-allowance-to-write-offs ratio. It shows how accurately the write-offs are absorbed by the allowance. If the allowance at the beginning of the year was not high enough to accommodate approaching write-offs, the ratio is expected to be rather low. On the other hand, high ratios might imply that excessive allowance might have been accumulated by the entity.
  3. Calculating the exhaustion rate of the allowance. Exhaustion rates express the number of years that was needed to write off the allowance amount from the beginning of the year.

Footnotes

  1. Cyert, R. M., Davidson, H. J., Thompson, G. L. 1962, 287-288.
  2. Kulikova L. I., Garyncev A. G., Goshunova A. V. 2015, 448.
  3. Kulikova L. I., Garyncev A. G., Goshunova A. V. 2015, 448-449.
  4. Kulikova L. I., Garyncev A. G., Goshunova A. V. 2015, 448.
  5. Riley M. E., Pasewark W. R. 2009, 40-44.

References

Author: Magdalena Wojslaw