## 3.1. Financial ratios to analyze allowance for doubtful accounts

Accountants or auditors can also use the following ratios to evaluate the allowance for doubtful accounts:

• Compare beginning allowance for doubtful accounts (BADA) to that year’s write-off amount (WO)
• Compare cumulative bad debt expense to cumulative write-off amount for the same multi-year period
• Assess allowance exhaustion rate

The above-listed ratios are summarized in the table below:

 Ratio Calculation Standard Range BADA to WO BADA ÷ WO 1.0 – 2.0 CBDE to CWO CBDR ÷ CWO 1.0 BADA utilization as WO BADA – WO until BADA = 0 1.0 – 2.0 years

Let’s continue our previous example to see how these ratios can be calculated.

 Au Logis Company Selected receivable-related information 20X2 20X1 20X0 (1) Beginning allowance for doubtful accounts (BADA) \$25,000 \$26,000 \$22,000 (2) Bad debt expense (BDE) 26,000 20,000 18,000 (3) Write-off (WO) (23,000) (21,000) (14,000) (4) Ending allowance for doubtful accounts (EADA) \$28,000 \$25,000 \$26,000 BADA to WO [ (1) ÷ (3) ] 1.09 1.24 1.57 CBDE to CWO [ Cumulative (1) ÷  Cumulative (3) ] (25,000 + 26,000 + 22,000 ) ÷ (23,000 + 21,000 + 14,000) = 73,000 ÷ 58,000 = 1.26 BADA for year 20X0 exhaustion Year 20X0: \$22,000 – \$14,000 = \$8,000 Year 20X1: all \$8,000 are exhausted => find year fraction: \$8,000 ÷ \$21,000 = 0.38 BADA 20X0 exhaustion: 1 + 0.38 = 1.38 years BADA for year 20X1 exhaustion Year 20X1: \$26,000 – 21,000 = \$5,000 Year 20X2: \$5,000 ÷ \$23,000 = 0.22 BADA 20X1 exhaustion: 1.22 years

Each year analysts can compare the beginning allowance for doubtful accounts to the write-off amount during that year. In our example, each year the ratio is within the standard range. A relatively large ratio could indicate that a company is accumulating excessive allowance while a relatively low ratio could show that the company is underestimating the allowance.

Comparing bad debt expense to write-off amount is one of the measures of the accuracy of bad debt estimates. It is better to compare bad debt expense ratio over time. In our example, this ratio equals 1.26, which is within acceptable range. Ideally the ratio of bad debt expense to write-off amount should equal 1.0. When the ratio is more than 1.0, the company tends to accumulate excessive allowance (over-estimate).

For both ratios, it is useful to look at a multi-period trend (e.g., 5-10 years) and calculate the mean and standard deviation over time.

Finally, the third ratio measures the time it takes to use a beginning allowance for doubtful accounts to cover an actual write-off. In our example, it took Au Logis Company 1.38 years to use the 20X0 BADA and 1.22 years to use the 20X1 BADA.

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