What Is Asset Allocation?

Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance, and investment horizon. The three main asset classes—equities, fixed-income, and cash and equivalents—have different levels of risk and return, so each will behave differently over time.

Why Asset Allocation Is Important

There is no simple formula that can find the right asset allocation for every individual. However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, the selection of individual securities is secondary to the way that assets are allocated in stocks, bonds, and cash and equivalents, which will be the principal determinants of your investment results.

Investors may use different asset allocations for different objectives. Someone who is saving for a new car in the next year, for example, might invest their car savings fund in a very conservative mix of cash, certificates of deposit (CDs), and short-term bonds. An individual who is saving for retirement that may be decades away typically invests the majority of their individual retirement account (IRA) in stocks, since they have a lot of time to ride out the market’s short-term fluctuations. Risk tolerance plays a key factor as well. Someone who is uncomfortable investing in stocks may put their money in a more conservative allocation despite a long-term investment horizon.

Age-Based Asset Allocation

In general, stocks are recommended for holding periods of five years or longer. Cash and money market accounts are appropriate for objectives less than a year away. Bonds fall somewhere in between. In the past, financial advisors have recommended subtracting an investor’s age from 100 to determine what percentage should be invested in stocks. For example, a 40-year-old would be 60% invested in stocks. Variations of the rule recommend subtracting age from 110 or 120, given that the average life expectancy continues to grow. As individuals approach retirement age, portfolios should generally move to a more conservative asset allocation to help protect assets.

Achieving Asset Allocation Through Life-Cycle Funds

Asset-allocation mutual funds, also known as life-cycle, or target-date, funds, are an attempt to provide investors with portfolio structures that address an investor’s age, risk appetite, and investment objectives with an appropriate apportionment of asset classes. However, critics of this approach point out that arriving at a standardized solution for allocating portfolio assets is problematic because individual investors require individual solutions.

The Vanguard Target Retirement 2030 Fund would be an example of a target-date fund. These funds gradually reduce the risk in their portfolios as they near the target date, cutting riskier stocks and adding safer bonds in order to preserve the nest egg. The Vanguard 2030 fund, set up for people expecting to retire between 2028 and 2032, had a 65% stock/35% bond allocation as of Jan. 31, 2022. As 2030 approaches, the fund will gradually shift to a more conservative mix, reflecting the individual’s need for more capital preservation and less risk.

Bottom Line

Most financial professionals will tell you that asset allocation is one of the most important decisions that investors make. In other words, the selection of individual securities is secondary to the way that assets are allocated in stocks, bonds, and cash and equivalents, which will be the principal determinants of your investment results.

What Is Asset/Liability Management?

Asset/liability management is the process of managing the use of assets and cash flows to reduce the firm’s risk of loss from not paying a liability on time. Well-managed assets and liabilities increase business profits. The asset/liability management process is typically applied to bank loan portfolios and pension plans. It also involves the economic value of equity.

Understanding Asset/Liability Management

The concept of asset/liability management focuses on the timing of cash flows because company managers must plan for the payment of liabilities. The process must ensure that assets are available to pay debts as they come due and that assets or earnings can be converted into cash. The asset/liability management process applies to different categories of assets on the balance sheet.

[Important: A company can face a mismatch between assets and liabilities because of illiquidity or changes in interest rates; asset/liability management reduces the likelihood of a mismatch.]

Factoring in Defined Benefit Pension Plans

A defined benefit pension plan provides a fixed, pre-established pension benefit for employees upon retirement, and the employer carries the risk that assets invested in the pension plan may not be sufficient to pay all benefits. Companies must forecast the dollar amount of assets available to pay benefits required by a defined benefit plan.

Assume, for example, that a group of employees must receive a total of $1.5 million in pension payments starting in 10 years. The company must estimate a rate of return on the dollars invested in the pension plan and determine how much the firm must contribute each year before the first payments begin in 10 years.

Examples of Interest Rate Risk

Asset/liability management is also used in banking. A bank must pay interest on deposits and also charge a rate of interest on loans. To manage these two variables, bankers track the net interest margin or the difference between the interest paid on deposits and interest earned on loans.

Assume, for example, that a bank earns an average rate of 6% on three-year loans and pays a 4% rate on three-year certificates of deposit. The interest rate margin the bank generates is 6% – 4% = 2%. Since banks are subject to interest rate risk, or the risk that interest rates increase, clients demand higher interest rates on their deposits to keep assets at the bank.

The Asset Coverage Ratio

An important ratio used in managing assets and liabilities is the asset coverage ratio which computes the value of assets available to pay a firm’s debts. The ratio is calculated as follows:


$\begin{aligned} &\text{Asset Coverage Ratio} = \frac{ ( \text{BVTA} – \text{IA} ) – ( \text{CL} – \text{STDO}) }{ \text{Total Debt Outstanding} } \\ &\textbf{where:} \\ &\text{BVTA} = \text{book value of total assets} \\ &\text{IA} = \text{intangible assets} \\ &\text{CL} = \text{current liabilities} \\ &\text{STDO} = \text{short term debt obligations} \\ \end{aligned}$​Asset Coverage Ratio=Total Debt Outstanding(BVTA−IA)−(CL−STDO)​where:BVTA=book value of total assetsIA=intangible assetsCL=current liabilitiesSTDO=short term debt obligations​

Tangible assets, such as equipment and machinery, are stated at their book value, which is the cost of the asset less accumulated depreciation. Intangible assets, such as patents, are subtracted from the formula because these assets are more difficult to value and sell. Debts payable in less than 12 months are considered short-term debt, and those liabilities are also subtracted from the formula.

The coverage ratio computes the assets available to pay debt obligations, although the liquidation value of some assets, such as real estate, may be difficult to calculate. There is no rule of thumb as to what constitutes a good or poor ratio since calculations vary by industry.

Key Takeaways

• Asset/liability management reduces the risk that a company may not meet its obligations in the future.
• The success of bank loan portfolios and pension plans depend on asset/liability management processes.
• Banks track the difference between the interest paid on deposits and interest earned on loans to ensure that they can pay interest on deposits and to determine what a rate of interest to charge on loans.

[Fast Fact: Asset/liability management is a long-term strategy to manage risks. For example, a home-owner must ensure that they have enough money to pay their mortgage each month by managing their income and expenses for the duration of the loan.]

What Is an Auditor’s Report?

An auditor’s report is a written letter from the auditor containing their opinion on whether a company’s financial statements comply with generally accepted accounting principles (GAAP) and are free from material misstatement.

The independent and external audit report is typically published with the company’s annual report. The auditor’s report is important because banks and creditors require an audit of a company’s financial statements before lending to them.

How an Auditor’s Report Works

An auditor’s report is a written letter attached to a company’s financial statements that expresses its opinion on a company’s compliance with standard accounting practices. The auditor’s report is required to be filed with a public company’s financial statements when reporting earnings to the Securities and Exchange Commission (SEC).

However, an auditor’s report is not an evaluation of whether a company is a good investment. Also, the audit report is not an analysis of the company’s earnings performance for the period. Instead, the report is merely a measure of the reliability of the financial statements.

The Components of an Auditor’s Report

The auditor’s letter follows a standard format, as established by generally accepted auditing standards (GAAS). A report usually consists of three paragraphs.

• The first paragraph states the responsibilities of the auditor and directors.
• The second paragraph contains the scope, stating that a set of standard accounting practices was the guide.
• The third paragraph contains the auditor’s opinion.

An additional paragraph may inform the investor of the results of a separate audit on another function of the entity. The investor will key in on the third paragraph, where the opinion is stated.

The type of report issued will be dependent on the findings by the auditor. Below are the most common types of reports issued for companies.

Clean or Unqualified Report

A clean report means that the company’s financial records are free from material misstatement and conform to the guidelines set by GAAP. A majority of audits end in unqualified, or clean, opinions.

Qualified Opinion

A qualified opinion may be issued in one of two situations: first, if the financial statements contain material misstatements that are not pervasive; or second, if the auditor is unable to obtain sufficient appropriate audit evidence on which to base an opinion, but the possible effects of any material misstatements are not pervasive. For example, a mistake might have been made in calculating operating expenses or profit. Auditors typically state the specific reasons and areas where the issues are present so that the company can fix them.

Adverse Opinion

An adverse opinion means that the auditor has obtained sufficient audit evidence and concludes that misstatements in the financial statements are both material and pervasive. An adverse opinion is the worst possible outcome for a company and can have a lasting impact and legal ramifications if not corrected.

Disclaimer of Opinion

A disclaimer of opinion means that, for some reason, the auditor is unable to obtain sufficient audit evidence on which to base the opinion, and the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive. Examples can include when an auditor can’t be impartial or wasn’t allowed access to certain financial information.

Example of an Auditor’s Report

Excerpts from the audit report by Deloitte & Touche LLP for Starbucks Corporation, dated Nov. 15, 2019, follow.

Paragraph 1: Opinion on the Financial Statements

“We have audited the accompanying consolidated balance sheets of Starbucks Corporation and subsidiaries (the ‘Company’) as of September 29, 2019, and September 30, 2018, the related consolidated statements of earnings, comprehensive income, equity, and cash flows, for each of the three years in the period ended September 29, 2019, and the related notes (collectively referred to as the ‘financial statements’).

In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of September 29, 2019, and September 30, 2018, and the results of its operations and its cash flows for each of the three years in the period ended September 29, 2019, in conformity with accounting principles generally accepted in the United States of America.”

Paragraph 2: Basis for Opinion

“We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (PCAOB). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks.

Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.”

What Is an Allowance for Doubtful Accounts?

An allowance for doubtful accounts is a contra account that nets against the total receivables presented on the balance sheet to reflect only the amounts expected to be paid. The allowance for doubtful accounts estimates the percentage of accounts receivable that are expected to be uncollectible. However, the actual payment behavior of customers may differ substantially from the estimate.

Understanding the Allowance for Doubtful Accounts

Regardless of company policies and procedures for credit collections, the risk of the failure to receive payment is always present in a transaction utilizing credit. Thus, a company is required to realize this risk through the establishment of the allowance for doubtful accounts and offsetting bad debt expense. In accordance with the matching principle of accounting, this ensures that expenses related to the sale are recorded in the same accounting period as the revenue is earned. The allowance for doubtful accounts also helps companies more accurately estimate the actual value of their account receivables.

Because the allowance for doubtful accounts is established in the same accounting period as the original sale, an entity does not know for certain which exact receivables will be paid and which will default. Therefore, generally accepted accounting principles (GAAP) dictate that the allowance must be established in the same accounting period as the sale, but can be based on an anticipated or estimated figure. The allowance can accumulate across accounting periods and may be adjusted based on the balance in the account.

How to Estimate the Allowance for Doubtful Accounts

Two primary methods exist for estimating the dollar amount of accounts receivables not expected to be collected.

Percentage of Sales Method

The sales method applies a flat percentage to the total dollar amount of sales for the period. For example, based on previous experience, a company may expect that 3% of net sales are not collectible. If the total net sales for the period is $100,000, the company establishes an allowance for doubtful accounts for $3,000 while simultaneously reporting $3,000 in bad debt expense.

If the following accounting period results in net sales of $80,000, an additional $2,400 is reported in the allowance for doubtful accounts, and $2,400 is recorded in the second period in bad debt expense. The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400.

Accounts Receivable Aging Method

The second method of estimating the allowance for doubtful accounts is the aging method. All outstanding accounts receivable are grouped by age, and specific percentages are applied to each group. The aggregate of all group results is the estimated uncollectible amount.

For example, a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding. Based on previous experience, 1% of accounts receivable less than 30 days old will be uncollectible, and 4% of those accounts receivable at least 30 days old will be uncollectible.

Therefore, the company will report an allowance of $1,900 (($70,000 * 1%) + ($30,000 * 4%)). If the next accounting period results in an estimated allowance of $2,500 based on outstanding accounts receivable, only $600 ($2,500 – $1,900) will be the adjusting entry amount.

Risk Classification Method

Some companies may classify different types of debt or different types of vendors using risk classifications. For example, a start-up customer may be considered a high risk, while an established, long-tenured customer may be a low risk. In this example, the company often assigns a percentage to each classification of debt. Then, it aggregates all receivables in each grouping, calculates each group by the percentage, and records an allowance equal to the aggregate of all products.

Historical Percentage Method

If a company has a history of recording or tracking bad debt, it can use the historical percentage of bad debt if it feels that historical measurement relates to its current debt. For example, a company may know that its 10-year average of bad debt is 2.4%. Therefore, it can assign this fixed percentage to its total accounts receivable balance since more often than not, it will approximately be close to this amount. The company must be aware of outliers or special circumstances that may have unfairly impacted that 2.4% calculation.

Pareto Analysis Method

A Pareto analysis is a risk measurement approach that states that a majority of activity is often concentrated among a small amount of accounts. In many different aspects of business, a rough estimation is that 80% of account receivable balances are made up of a small concentration (i.e. 20%) of vendors. This 80%/20% ratio is used throughout business.

Though the Pareto Analysis can not be used on its own, it can be used to weigh accounts receivable estimates differently. For example, a company may assign a heavier weight to the clients that make up a larger balance of accounts receivable due to conservatism.

Specific Identification Method

Assume a company has 100 clients and believes there are 11 accounts that may go uncollected. Instead of applying percentages or weights, it may simply aggregate the account balance for all 11 customers and use that figure as the allowance amount. Companies often have a specific method of identifying the companies that it wants to include and the companies it wants to exclude.

How to Account for the Allowance for Doubtful Accounts

Establishing the Allowance

The first step in accounting for the allowance for doubtful accounts is to establish the allowance. This is done by using one of the estimation methods above to predict what proportion of accounts receivable will go uncollected. For this example, let’s say a company predicts it will incur $500,000 of uncollected accounts receivable.

To create the allowance, the company must debit a loss. Most often, companies use an account called ‘Bad Debt Expense’. Then, the company establishes the allowance by crediting an allowance account often called ‘Allowance for Doubtful Accounts’. Though this allowance for doubtful accounts is presented on the balance sheet with other assets, it is a contra asset that reduces the balance of total assets.

• DR Bad Debt Expense $500,000
• CR Allowance for Doubtful Accounts $500,000

Adjusting the Allowance

Let’s say six months passes. The company now has a better idea of which account receivables will be collected and which will be lost. For example, say the company now thinks that a total of $600,000 of receivables will be lost. This means its allowance of $500,000 is $100,000 short. The company must record an additional expense for this amount to also increase the allowance’s credit balance.

• DR Bad Debt Expense $100,000
• CR Allowance for Doubtful Accounts $100,000

Writing Off Account

Now, let’s say a specific customer that owes a company $50,000 officially files for bankruptcy. This client’s account had previously been included in the estimate for the allowance. Because the company has a very low priority claim without collateral to the debt, the company decides it is unlikely it will every receive any of this $50,000. To properly reflect this change, the company must reduce its accounts receivable balance by this amount. On the other hand, once the receivable is removed from the books, there is no need to record an associated allowance for this account.

• DR Allowance for Doubtful Accounts $50,000
• CR Accounts Receivable $50,000

Note that the debit to the allowance for doubtful accounts reduces the balance in this account because contra assets have a natural credit balance. Also, note that when writing off the specific account, no income statement accounts are used. This is because the expense was already taken when creating or adjusting the allowance.

Recovering an Account

By miracle, it turns out the company ended up being rewarded a portion of their outstanding receivable balance they’d written off as part of the bankruptcy proceedings. Of the $50,000 balance that was written off, the company is notified that they will receive $35,000.

The company can recover the account by reversing the entry above to reinstate the accounts receivable balance and the corresponding allowance for doubtful account balance. Then, the company will record a debit to cash and credit to accounts receivable when the payment is collected. You’ll notice that because of this, the allowance for doubtful accounts increases. A company can further adjust the balance by following the entry under the “Adjusting the Allowance” section above.

• DR Accounts Receivable $35,000
• CR Allowance for Doubtful Accounts $35,000
• DR Cash $35,000
• CR Accounts Receivable $35,000

The Bottom Line

The allowance for doubtful accounts is a general ledger account that is used to estimate the amount of accounts receivable that will not be collected. A company uses this account to record how many accounts receivable it thinks will be lost. The balance may be estimated using several different methods, and management should periodically evaluate the balance of the allowance account to ensure the appropriate bad debt expense and net accounts receivables are being recorded.