Bad Debt Write-offs

The Bad Debt Allowance and Write-Offs

Image Group
istockphoto
Approximately 39 percent of the BDA gets written-off, according to CSI research, for an average allowance to write-off ratio of 2.56:1.

Company management must make a variety of estimates and judgments but few are as significant as the one that lies at the intersection of credit, accounting and sales.  "Collectibility is improbable."

As late as 1999, Microage was seemingly still on a roll.  The publicly-traded computer wholesale distributor based in Tempe, Arizona had reached $6.1 billion in sales, the technology bubble was still in full swing and although Microage's market capitalization was excessively low in comparison to revenue most creditors didn't seem to care. That soon changed, however, when on April 20, 2000 the company filed for Chapter 11 bankruptcy. 

Although some creditors did eventually receive their money due to asset liquidation, creditor losses could have been greatly diminished or even avoided all together if closer attention had been paid to Microage's bad debt allowance, which was rising at a much faster pace than sales (see chart below).  Finding the allowance would have required some looking as those figures along with the write-offs were tucked away in a table at the end of the footnotes of the company's annual report. 

Microage is just one in a near countless number of cases in which the bad debt allowance, if properly estimated, has exposed credit, sales and managerial weaknesses within a company.  A contra account (see below) strategically positioned between the accounts receivable on the balance sheet and the expense portion of the income statement, the bad debt allowance provides a window into the structural and managerial integrity of a company like no other ratio.

Definition

The bad debt allowance is an estimate of the amount of the accounts receivable that a company expects will be uncollectible.  This estimate, made in advance of any write-offs, is necessary in keeping with the matching principle of accrual accounting, in which revenue for a given period is matched with expenses for the same period.  Accrual accounting was developed almost a century ago as a way to determine the real profit or loss of a company. 

The bad debt allowance, also known as the allowance for doubtful accounts, gains much of its value as a financial ratio because of the insight it provides into the strategic thinking of a company.  BDA is the one figure in which management has complete control unlike the other areas of a company's financial statements that are often influenced by operational and market factors outside of management's direct control.

It consistently ranks at or near the top in the importance of managerial estimates and judgments along with inventory valuation, warranty liabilities and goodwill impairment, according to CreditPulse research of company annual reports.  It is also one of the main performance indicators for credit risk management.

The accounting for bad debts, however, is somewhat complex.  In accrual accounting, the method used by all but the smallest businesses, the accounting for bad debt is done indirectly through a contra, or offsetting, account on the general ledger.  To establish or increase the allowance, a debit journal entry is made to bad debt expense and a corresponding credit (a reduction) is made to the bad debt allowance, the contra account.  The entries are reversed in order to decrease the allowance. 

But those entries merely establish the allowance or the receivables amount estimated to go bad.  Once a write-off does occur, the bad debt allowance account is then debited, the offset to the previous credit, and the accounts receivable itself is credited, which then reduces the a/r for the amount uncollected (assets are increased with a debit and decreased with a credit). 

Thus, it is important to note that the accounts receivable itself is never affected until the actual write-off takes place even though the allowance amount is always netted out or deducted from the accounts receivable figure reported on the balance sheet for financial reporting purposes.

Estimating the Allowance

The bad debt allowance was created in March 1975 when the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 5, Accounting for Contingencies.  The rule, only the fifth issued by the accounting rules-making body, provided much needed guidance to companies on how and when to account for receivables that were not being collected. 

The rule states that "losses from uncollectible receivables shall be accrued when...it is probable that an asset had been impaired" and the "amount of the loss can be reasonably estimated."  The rule defines probable as "the future event or events are likely to occur."  The ruling went on to say that "whether the amount of loss can be reasonably estimated will normally depend on, among other things, the experience of the enterprise, information about the ability of individual debtors to pay, and appraisal of the receivables in light of the current economic environment."

CreditPulse research into thousands of company annual reports spanning 70 industries shows that most companies consider the following five key factors when estimating the allowance for doubtful accounts:

1.  Length of time receivables are past due.  The aging report remains one of the principle instruments for estimating bad debt.  In fact, many companies will automatically reserve a portion or all of the accounts receivable portfolio once it has aged beyond a set number of days.

2.  Customer credit-worthiness.  The customer credit report and credit history remains the standby for which delinquency probability decisions are made.  Some companies knowingly extend credit to risky customers with the intent of reserving the receivable for financial reporting purposes.

3.  Past transaction history. Historical payment patterns are critical in determining the probability of future delinquency.

4.  Macroeconomic and industry conditions.  Economic conditions play a vital role in a businesses ability to function, grow and continue to pay its bills.  Economic conditions as a whole and how they affect various industries are often taken into consideration when estimating future losses.

5.  Changes in payment terms.  Many companies don't fully comprehend the affect that payment terms have on payment.  A high days sales outstanding (DSO) increases the likelihood of delinquency whether by design or not.

The bad debt allowance plays a valuable role in determining whether a company's credit policy is too restrictive or too liberal.  Most businesses expect a small percentage of their receivables to be uncollectible.  But an allowance too high indicates the firm is extending credit too easily; an allowance too low could indicate the firm is losing potential sales with a credit policy that is too restrictive. 

Next in the series CreditPulse will examine the bad debt allowance industry-by-industry using information gathered by the 2,082 company Credit Standards Index (CSI).