Allowance for Doubtful Accounts

For a financial institution, it is not only critical but regulated/audited.

From an accounting point of view (and for all other industries), the matching principle (and maybe conservatism?) applies and should be managed like any other amortization. The more critical issue is determining the manner/%/amount of allowance.

Set it and forget it, which I don't agree with. It's been the same amount since I began working at the company.

I don't think the company's current amount sitting on the balance sheet complies with the matching principle. Since the auditor signs off on it and the company managers thinks it's adequate, it must be.

Calculating possible future bad debt expense and allowance for doubtful accounts at our company is a hybrid of collections judgement and a function of A/R aging allowance methods.

We attach a risk score to accounts. To get our estimate for the allowance we look at individual A/R accounts that make up 80% of the total A/R outstanding and give each case-by-case ongoing attention and estimation. The remaining smaller accounts, which are more numerous, that make up the remaining 20% of A/R are generally given an historical average allowance by age.

I'd be interested in how others estimate their allowance for doubtful accounts. I, too, have little idea if this is totally in compliance or not.

Until the current calendar/fiscal year, we used a percentage of our entire AR balance - without accounting for the burden coming from our older items. We are now working our way towards a real calculation which takes a weighted approach to the allowance depending on the aging.

I have a real issue with just setting and forgetting. I think that is akin to just forgetting it altogether as it no longer means anything on the financial reports. Each industry is different and the type of collections activity and length of time will impact your allowance balance. If you can document the calculation (consistent application) and show how it matches historical trends in your company and industry wide you are actually reflecting something that can be used to monitor the health of a company.

I would like to hear more about this topic and how others calculate theirs as well.

This is all about estimating and management judgement as is signed off on in the audit representation letter (take a look at the rep letter as it should address this). For me, the best way to estimate is to look historically the bad debt as a percentage of the A/R aging (0 -30 days, 31-60 days, 61-90 days, 91- 120 days, over 120 days). If you don't have this historic data, ask your auditors for guidance and/or an industry group.

There are two methods to calculate your allowance for bad debt. One is by the percentage method (which David Rau explained). The method I prefer, which auditors will also agree to, is to review collectibility of the aging, and identify those accounts which have a low likelihood of payment. I adjust the allowance at year-end only - but it is adjusted annually.

Coming from a banking/regulated perspective, I disagree with David that the best basis is the A/R aging. Although it is "a" factor, it is not entirely sufficient.

It is the current QUALITY of the account/company and underlying external factors that is the best predictor of Bad Debts. A/R age is just a symptom (generally) but at the same time can also be exploited by companies. A few of us in here have indicated wanting to extend their Days Payable metrics. Does it really reflect the health of your company or your ability to pay? The phrase "using other people's money" comes to mind.

The "banking" methodology involves review of the account/company and classifying them in risk pools (Current, Doubtful, etc) with similar risk and applying historical loss percentage on these pools. There are numerous and varying materials on banking ALLL computation methodology.

Let me be clear, it entirely depends on the company to choose how meticulous their Bad Debts reserves are computed and the A/R aging (as a basis) surely is a legitimate methodology.

One side benefit of doing this methodology (to include "grading" your customers) is that it also impacts Sales and continually improve customer selection quality.