B U S I N E S S & I N D U S T R Y / A U D I T I N G

Assessing the Allowance for

Doubtful AccountsUsing historical data to evaluate the estimation process

by Mark E. Riley. CPA,Ph.D.. and William R. Pasewark. CPA.PhD.

Calnilatingestimitesofihecollectibilityofac- ing Standards (SAS) no. 57 and AU section 342,

counts receivable and auditing those estimates AudilingAccounlin^ Emmatcs, which suggest auditorsis difficult. This article describes three tech- compare prior accounting estimates with subsequent

niques for assessing dlowance for doubtful accounts results to evaluate the reliability of the process usedestimates and complying wa'h Statement on Audit- to develop estimates.

B U S I N E S S & I N D U S T R Y / A U D I T I N G

Exhibit 1 Techniques for Analyzing Estimates afUncollectible Receivables

Dell Inc. (in millions)

Beginning Ailowance for Doubtful Accounts

Bad Debt Expense

Write-Otts

Ending Ailowance for Doubttui Accounts

Technique

1. Compare Cumulative Bad Debt Expense

(ZBDE) to Cumulative Write-Otfs (2W0)over a iVIultiyear Period

2. Compare Each Years Beginning-of-Year Ailowance tor Doubttui Accounts(BADA) to Tbat Year's Write-Otfs (WO)

3, Assess the Aliowance ExhaustionRate—Number of years until beginning

allowance (BADA) is completely utilized inthe form of write-otts (WO)

2006 n79

101

(84)

96

96

107

(77)

126

W 2008126

82

(105)

103

Calculation

IßDE -:- ZWO

Example

For 2006 through 2008

($101 + 107 4 82) -̂ ($84 4- 77 4 105) =

Benchmark'

1.0 for a multiyear

BADA -:- WO

Start with BADA for year /(BADAi). Subtract each year'sannuai WD from BADA, untiiBADA, is exhausted. Divide

remaining ailowance at beginningot finai year by write-offs in that

year to compute partial year.

for 2008

{$126-$105) = 1.20

Using 2007 as year /

Unusedatendot1styear:$96-- $ 7 7 - $192nd year (partiai year): Remaining $19 is

utilized in 0.18 (S19 -- $105) year.2007 BADA is exhausted in1.18(1 + 0.18)

years.

1.0 to 2.0 tor a

typicai year

1 to 2 years

'These benchmarks represent the authors' opinions of reasonable resuits for each of the metrics demonstrated above. These benchmarks could differ basedon specific circumstances. Therefore, they should only be viewed as broad guideiines.

Accountants have typically reiied on ac-counts receivable aging as the primary toollor evaluating coilectibility. Aging allowscompanies to generate estimates of uncol-lectible accounts at specific times. Howev-er, the technique does nol consider the ac-curacy of past estimates, as mandated bySAS no. 57. An analysis of historical trendscan provide useful information about an en-

tity's past accuracy and possible biases in es-timating its allowance for doubtful accounts.

TECHNIQUES FOR ANALYZINGTHE ESTIMATE-GENERATINGPROCESSExhibit 1 uses three years of data from DellInc. to descrilje three simple techniques forassessing past estimates of the allowance for

doubtful accounts. Because ihe techniquesuse historical data, ihey give an indicationof the effectiveness of past eslimales. Afterthey are described, the techniques aredemonstrated using data from three tech-nology companies—Dell, Apple Inc., andCisco Systems Inc.—that exhibit marked-ly différent historical patterns in the esti-mation and use of their allowances for

w Aging is the most commontechnique used to value receiv-abies. However, several otheranalysis techniques can provideinsight regarding Ihe accuracy ofprior estimates and the effective-ness of the estimation process.• Comparing bad debtexpense each year to write-offs during that year is onemeasure of the accuracy of baddebt estimates. Calculating theratio over multiple periods, rather

E X E C U T I V E

than a single year, provides themost useful information.• Comparing the beginning al-lowance for doubtful accountsto subsequent write-offsdetermines the adequacy of theexisting allowance. Lower ratiosIndicate the allowance may betoo low, while higher ratios maysignify the accumulation of ex-cessive allowances.• The allowance exhaustionrate is the amount of time it

SUMMARY

takes to write off an allowance. Acorporation may be accumulat-ing excessive allowances if ittakes several years to exhaust itsallowance for doubtful accountsreceivable balance.• Evidence suggests thatsome companies have greatdifficulty in estimating coNectibili-ty. Accountants potentially bene-fit by using additional tools thatshed light on the accuracy ofpast estimates.

Mark E. Riley (meriley@niu.edu) is

an assistant professor at NorthernIllinois University. William R.

Pasewark (w.pasevi'ark@ttu.edu)is the Webster Professor ofAccounting at Texas Tech University.

To comment or} this article or tosuggest an idea for another

articie, contact Kim Nilsen,

editorial director, at knllsen^

aicpa.org or 919-402-4048.

www.journalofaccountancy.com September 2009 Journal of Accountancy 41

B U S I N E S S & I N D U S T R Y / A U D I T I N G

Exhibit 2 Analyzing Dell's Estimates of UncollectibleAccounts Receivable

standarddeviation of

Multiyear singie-yearMetric

BDE/WO

BADA/WO

2000

1.93

2.00

2001

1,81

1,42

2002

0.98

1.73

2003

1.08

1.89

2004

1.27

1.48

2005

0,94

1.26

2006

1.20

0.94

2007

1.39

1.25

2008

0,78

1.20

measure

1.15*

1.46*"

measures

0.39-•

0 . 3 5 "

BADA Exhaustion 1.48 1.33 1.81 1.67 1.35 1.20 0.94 1.18 " " N/A N/ARate {years)

' Multiyear measure of BDE/WO is computed by dividing the sum of bad debt expense recorded from 2000 to 2008 by tfie sum of write-offs for ttie sameperiod. BOE/WO for each individual year is computed by dividing bad debt expense for each year by write-offs for the same year.

* * Represents standard deviation of nine individual year figures for the period 2000 to 2006.

* * * Multiyear measure of 8ADA/W0 is the average oí the nine annual BADA/WO ratios for the period 2000 to 2008.

* " * Exhaustion rate cannot be determined because the entire beginning allowance for doubtful accounts has not been utilized (in the form of write-offs).

Exhibit 3 Analyzing Apple's Estimates of UncollectibleAccounts Receivable

Standarddeviation ot

Multiyear single-yearMetric

BDE/WO

BADA / WO

2000

0.56

7.56

2001

0.35

3.20

2002

1.00

5.10

2003

0.67

8.50

2004

0-60

9.80

2005

0.89

5.22

2006

1.55

4.18

2007

0.71

3.06

2008

1.00

15.67

measure

0.77"

6.92-••

measures

0 .35 "

4 . 0 3 "

BADA ExhaustionRate (years)

6.32 6.18 5.59 6.00 N/A N/A

' Multiyear measure ot BDE/WO is computed by dividing the sum of bad debt expense recorded from 2000 to 2008 by the sum of write-offs for the same

period, BDE/WO for each individual year is computed by dividing bad debt expense for each year by write-offs for the same year.

• ' Represents standard deviation of nine individual year figures for ttie period 2000 to 2008.

• " Multiyear measure of BADAAVO is the average of the nine annual BADA/WO ratios for the period 2000 to 2008.

" " Exhaustion rate cannot be determined because the entire beginning allowance for doubtful accounts has not been utilized (in tfie form of write-offs).

doLibiful accounts. All data used in this ar-ticle is available in these companies' filingsal secgov.

Technique I: Compare bad debt ex-pense (BDE) to write-offfi (WO). Bad debtexpense recorded in a specific year impliesthe necessity for write-offs during that yearand subsequent years. While it is unreal-istic to expect estimated bad debt expenseto perfectly match actual write-offs in agiven year, il is reasonable to expect theratio of bad debt expense to write-offs tobe close to 1.0 over an extended period.

Ratios calculated for multiple years thatare substantially lower than 1.0 might sug-

gest the entity tends to underestimate theimpact of collection problems. On theother hand, multiple-year ratios that sig-nificantly exceed 1.0 may signal that theentity is accumulating an excessive al-lowance. In addition, inspecting the indi-vidual year bad-debt-expense-to-write-offsratios, as well as the standard deviation ofthose measures, can give a sense of theconsistency of the relationship betweenthese two figures over time. A standard de-viation that is relatively low, when com-pared vnth the multiyear mean, is an in-dication of consistency.

Technique 2: Compare beginning al-

lowance for douhtju} accounts (BADA) towrite-offs (WO). This ratio is computedeach year using the beginn ing-of-yearallowance for doubtful accounts as thenumerator and write-offs of accounts re-ceivable recorded during the year as thedenominator. The beginning-allowance-to-write-offs ratio indicates how ade-quately the allowance accommodatedsubsequent write-offs. Lower ratios suggestthe beginning-of-year allowance may nothave been large enough to absorb im-pending write-ofTs, while inordinately highratios might indicate the entity was accu-mulating excessive allowances.

42 Journal of Accouniancy Soplemher 2009 www.journalofaccountancy.com

B U S I N E S S & I N D U S T R Y / A U D I T I N G

Exhibit 4 Analyzing Cisco's Estimates of UncollectibleAccounts Receivable

standarddeviation ot

Multiyear single-yearMetricBDE/WO

BADA / WO

ZOOO1,67

1.13

200111.65

1.87

20022.07

6.55

2003-0.63

3,60

20040,83

7,96

20050,00

10.53

20062.18

14,73

20070.40

11.67

20081.487.22

measure1.55'

7 . 2 5 " '

measures3 . 6 8 "4 . 5 7 "

BADA Exhaustion 1.13 1.45 ' " * * " " " ' * * ' " * * " " N/A N/ARate (years)

' Multiyear measure of BDE/WO is computed by dividing the sum of bad öebt expense recorded from 2000 to 2008 öy the sum of write-offs for the sameperiod. BDE/WO for each individual year is computed by dividing bad debt expense for each year by write-offs for the same year,* * Represents standard deviation of nine individual year figures for the period 2000 to 2008,' * ' Multiyear measure of BADAA/VO is the average of the nine annual BADA/WO ratios for the period 2000 to 2008," * " Exhaustion rate cannot be determined because the entire beginning allowance for doubtful accounts has not been utilized {in the form of write-offs).

U is useful 10 examine boih the meanand standard deviation of the beginning-allowance-to-write-offs ratio over a periodof several years. The tnean can be com-pared to the benchmark figure of one toLwo years to determine whether a firm's al-lowance for doubtful accounts balance isreasonable in relation to subsequent write-offs. Meanwhile, the standard deviation ofthe ratio measures volatility. A relativelylow standard de\'iation, in comparison toihe multiyear mean, signals consistency Arelatively high standard deviation indicatesa volatile relationship between the al-lowance and subsccjuent write-offs.

Technique 3: Assess the allowance ex-hciustion rate. Exhaustion rates indicate[he time (expressed in years) taken to usethe beginning-of-year allowance in theform of actual write-offs. For example, acompany vvdth a beginning allowance fordoubtful accounts of Î I million in yearone, and write-offs of $700,000 in yearone and $600,000 in year lwo would ex-hausi its allowance in 1.5 years ($1 mil-lion - $700,000 = $300,000 left for thenext year; $300.000 - $600,000 = 0.5years),

T\m TECHNIQUES IN ACTIONrhe three example corporations, Dell,,\pple and Cisco—all manufacturers in thehigh-tech industry—exhibit very different

patterns when estimating coUectibiiity andestablishing allowances.

Dell's bad-debt-expense-to-write-offratio (see Exhibit 2) for ihe nine years from2000 to 2008 is 1.15, which is reasonablyclose to the benchmark of 1,0. AlthoughDell exhibited two years of possible over-estimation in relation to actual write-offsin 2000 and 2001, the company has moreclosely matched bad debi expense wiihwrite-offs since 2002,

deviation of Dell's beginning-allowance-to-write-offs ratio over nine years is a rela-tively low 0-35, indicating a good deal ofconsistency in ihe relationship between theallowance for doubtful accounts balanceand subsequent write-offs.

On average, Apple's bad debt expense(see Exhibit 3) has been significantly lowerthan Its write-ofTs for the past nine years.The muUiyear bad-debt-expense-to-wTite-off ratio of 0,77 shows that Apple's bad

While economic circumstances vary,historical trends provide useful information about

the process used to form estimates.

Interestingly, Dell's bad debt expenseincreased over the past few years. Dell's in-creased write-off activity in the past fewyears is likely evidence that the higher ex-penses are warranted. In fact, write-offsduring the pasl four years are only slighl-ly lower than the beginning balances inDell's allowance for doubtful accounts, in-dicating that Deli has been successful atpredicting anticipated vmte-offs. This con-clusion is reinforced by Dell's beginning-allowance-to-write-offs ratio and its ex-haustion rate, both of which indicate Delltends to exhaust its allowance in a littleover one year. In addition, the standard

debt expense for the nine years has fallenshort of ihe write-offs it recorded over thesame period.

However, the beginning-allowance-to-write-offs ratio and exhaustion rates indi-cate that Apple's allowance for doubtful ac-counts was exceedingly high prior lo2000. On average, Apple had a beginning-of-lhe-year allowance for doubtful ac-counts that was almost seven times high-er than annual write-offs from 2000 to2008. The inconsistency in ihe relation-ship between Apple's allowance balanceand write-offs is evidenced by the high, rel-ative to ihe mean, standard deviation of

www.journalofaccountancy.com September 2009 Journal of Accountancy 43

B U S I N E S S & I N D U S T R Y / A U D I T I N G

ihm ratio over the period. This inference ofinconsistency is confirmed upon review ofihe wide range (from lows of 3.20 in 2001and 3.06 in 2007 to a high of 15.67 in2008) exhibited by Apple's beginning-al-lowance-to-write-offs ratio over the period.

By recording cumulative bad debt ex-pense that fell short of write-offs over thepast nine years, Apple has taken steps toadjust its allowance downward over time.However, Apple does noi appear to havecompletely eliminated its excess al-lowance. Apple's annual write-offs con-tinue, even in 2007 and 2008, to fall farshort of ils beginning allowance.

Apple's exhaustion rale data is partic-ularly informative. The analysis indicatesthat Apple maintains an extraordinarilylarge allowance for doubtful accounts. As

to correct ihe estimation problem in 2003by recognizing a negative expense, the largebad debt expense recorded in 2002 re-mained untapped (in the fomi of write-offs)as of 2008. The atialyses indicate that Ciscoand its auditors might want to consider thereasons an allowance of this magnitude wasrecorded and whether those or other reasonscontinue tojustify Cisco's current allowance.Cisco's estimation history wiih respect lo theallowance for doubtful accounts illustratesthe potential for overestimates of bad debtexpense to have long-lasting effects.

IMPLICATIONS OF THEANALYSISAssessing the effectiveness of past esti-mates provides a potential basis for confi-dence in future estimates. The techniques

Auditors should keep in mind that accountingestimates, such as the allowance for doubtful

accounts, can be used to manage earnings.

of the end of 2008, Apple had not yet ex-hausted the allowance that was in place atthe beginning of 2004. These analyses in-dicate a possible need for Apple and its au-ditors to critically re-examine the estima-tion process.

A review of the bad-debt-expense-to-write-off ratio for Cisco Systems (see Exhibit4) indicates the relationship Í>etween baddebt expense and write-oifs has been high-ly erratic. Cisco's estimation challengesmight be linked to the Internet bubble ofihe early 2000s. Possibly in anticipation ofcustomer nonpayment associated with thebursting of the Internet bubble, Cisco rec-ognized an exceptionally large bad debt ex-pense in 2001 and, to a lesser extent, 2002.Subsequent write-offs were relativelysmall. Similar to Apple, Cisco's beginning-allowance-to-write-offs ratio over the nine-year period indicates possibly excessiveallowances. In addition, the rano reveals aninconsistent relationship between the bal-ance in ihe allowance for doubtful accountsand later write-offs.

Although an apparent auempt was made

illustrated in ibis article are designed tohelp with and clarify assessment of an en-tity's past success in estimating its al-lowance for doubtful accounts. While eco-nomic circumstances vary, historicaltrends provide useful information aboutthe process used to form estimates.

AU section 342.04 states that estimates'subjective nature makes these decisionsvulnerable to bias and that such bias is like-ly to be present under any economic con-ditions. If prior trends suggest that an auditclient has regularly over- or underestimat-ed its allowance, but has not done so in aneffort to manipulate net income or finan-cial ratios, then the treatment under FASBStatement no. 154, Accouniing Changes anJError Corrections, is clear. The adjustmentis considered a change in estimate and isaccounted for prospectively.

On the other hand, if prior misstale-ments oí the allowance were material lothe financial statements as a whole andwere intentional, a restatement of prior pe-riods is required. We're aware of no evi-dence indicating that any of the companies

in our analysis used the allowance fordoubtful accounts to intentionally misstateor manipulate any financial results.

However, auditors should keep in mindthat accounting estimates, such as the al-lowance for doubtful accounts, can beused to manage earnings. For example, acompany might opportunistically reducethe allowance in a period of reduced earn-ings. Auditors are wise to weigh all avail-able evidence, including data related toprior estimates and the client's current fi-nancial condition, when a client propos-es a substantial reduction in or increase toits allowance for doubtful accounts.

A broader look at the industry in whichApple, Cisco and Dell operate reveals thatestimating the allowance for doubtful ac-counts is not an easy task. In examiningdata for fiscal years starting in 2000 andending in 2007 for 111 firms (eight annualobservations per firm, or 888 observationsin total) in the industrial and commercialmachinery and computer equipmentgroup (two-digit SIC code 35), we foundthat 21.1% of corporations had surpris-ingly large allowances. This group in-cluded 65 instances in which firms record-ed either negative or no write-oiTs duringthe year and 123 cases in which theBADAAVO ratio was 10.0 or higher.

We noted allowances that were possi-bly inadequate in almost 5% of the fimiyears we examined, finding 44 cases inwhich annual write-offs exceeded the be-gitining allowances for the years in wbichthe write-offs occurred. Initial results ofour research indicate that such inconsis-tencies in the relationship between the be-ginning allowance for doubtful accountsand the amount of write-offs taken duringthe year exist in other industries as well.

It is crucial for accounting profession-als to use all available tools to understandthe effectiveness of pasl estimates andmaintain the confidence of financial state-ment users in the stated net receivables.The techniques demonstrated in this arti-cle will help auditors comply with SAS no,57 and assess clients' current allowancesby providing valuable iníonnation abouithe accuracy of past estimates. •

44 Journal of Accounlancy Septemher 200*̂ www.journalofaccountancy.com