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

Allowance for doubtful debts is a high risk area due to the use of estimates which at times are difficult to use.

Allowance for doubtful debts must always be allocated as a reserve for debtors who will not be able to clear their debts.So this accounts will be substituted for the bad debts written off.The accountant should always know he approximate amounts of bad debts annually.He can also be helped by the internal auditor to compute the estimates for bad debts.

The auditor's role in this case is to ensure that he amount allocated for doubtful debt is sufficient;it is not too high or too low and also to ensure that if a bad debt written off is paid,it should be recorded.

To audit this,the auditor should first compare the amount of bad debts to write-offs.Then he can compare the beginning allowance for doubtful debts to write-offs.Also he should asses the allowance exhaustion rate.