3. Analysis of allowance for doubtful accounts

At the year end, companies estimate the amount of uncollectible accounts. Company management uses a great deal of judgment and discretion to determine the allowance for doubtful accounts. This account affects both assets (i.e., accounts receivable) and net income (i.e., bad debt expense). In contrast, when accounts become uncollectible, the write-off does not affect total assets and net income. As the result, it is important to evaluate the adequacy of the allowance for doubtful accounts.

It can often represent a difficult task to measure the adequacy of the allowance for doubtful accounts. One way analysts can do that is by comparing the allowance for doubtful accounts to the year-end balance in accounts receivable. Then, analysts can see the trend over time: Has the allowance percentage increased or decreased? The formula is presented below:

 Allowance for Doubtful Accounts as % of A/R = Allowance for Doubtful Accounts Accounts Receivable

Let’s look at the previous example. Au Logis Company (a fictitious entity) manufactures and sells home furniture and décor. Selected accounts receivable-related information for the company is presented below:

 Au Logis Company Selected receivable-related information 20X2 20X1 Accounts receivable (gross) \$28,000 \$25,000 Allowance for doubtful accounts \$4,000 \$5,000 Sales \$200,000 \$250,000 Allowance as % accounts receivable 14.29% 20.00%

As can be seen in the table above, the allowance percentage decreased in 20X2. There could be many reasons for such a decrease and looking at percentages of allowance as it relates to accounts receivable in vacuum may be misleading. In such cases, it can be a good idea to compare Au Logis Company to its competitors and industry trends.

For instance, accountants usually evaluated the collectability of accounts receivable: the aging of accounts receivable can be used in this case. However, it is better to evaluate the adequacy of past estimates as well and look at the historical trends of the company to assess the accuracy and biases of the company’s management in estimating the allowance for doubtful accounts.

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