Articles — Bad Debt Reserves

Arti­cles

Prin­ci­ples of Cal­cu­lat­ing Bad Debt Reserves

Prin­ci­ples of Cal­cu­lat­ing Bad Debt Reserves
March 1, 2003, By Dean Kaplan

A recent sur­vey con­ducted by CFO mag­a­zine showed that when audi­tors chal­lenge finan­cial state­ments, two thirds of the time it is a reserve bal­ance that is being ques­tioned. In today’s envi­ron­ment of increased focus on finan­cial state­ments, audi­tors are review­ing bad debt expenses and receiv­ables reserves more closely than ever. And in these dif­fi­cult eco­nomic times, there has been a sub­stan­tial increase in the num­ber of com­pa­nies hav­ing dif­fi­culty pay­ing bills on time or at all. Lately, it has been com­mon for us to have exten­sive reviews with clients at quarter-end to prop­erly esti­mate com­mer­cial receiv­able reserves and doc­u­ment jus­ti­fi­ca­tion for these estimates.

In larger com­pa­nies, typ­i­cally the his­tor­i­cal aver­age per­cent­age of uncol­lected sales is rec­og­nized as a loss when rev­enue is rec­og­nized (e.g., daily) so that interim inter­nal finan­cial reports reflect this expense. The amount recorded as an expense on the income state­ment is added to the reserve account on the bal­ance sheet. Any receiv­able write-offs dur­ing the period result in a decrease to the reserve balance.

Audi­tors focus on the reserve level for the spe­cific receiv­ables out­stand­ing at the end of a report­ing period. Typ­i­cally, audi­tors will require an increase in the reserve and a cor­re­spond­ing increase in the bad debt expense dur­ing the report­ing period if, in their opin­ion, losses on the receiv­ables will be greater than the reserve balance.

Meth­ods of Esti­mat­ing Bad Debt Reserves

There are a wide vari­ety of ways to esti­mate losses. In most cases, it involves apply­ing his­tor­i­cal aver­age per­cent­ages to today’s bal­ances. A com­mon, sim­ple approach is based solely on the age of receiv­ables (e.g., the older the receiv­able, the higher the loss %). A sam­ple cal­cu­la­tion is shown in Table 1.

But this approach typ­i­cally is not suf­fi­cient for CFO’s or audi­tors of pub­licly traded com­pa­nies. A finer analy­sis is desired for bet­ter under­stand­ing poten­tial losses and min­i­miz­ing them in the future.

Usu­ally the first step is seg­re­gat­ing accounts that have been placed for col­lec­tion or filed bank­ruptcy from other receiv­ables. Loss per­cent­ages, includ­ing exter­nal col­lec­tion and legal costs on poten­tial recov­er­ies, are applied to these seg­re­gated items.

Com­pa­nies that score their cus­tomers fre­quently have dif­fer­ent esti­mated loss rates for receiv­ables from dif­fer­ent qual­ity cus­tomers. An exam­ple of this is shown in Table 2.

Esti­mated reserves may also be adjusted based on the size of the receiv­able, col­lat­eral, the length of time a com­pany has been a cus­tomer, or recently imple­mented changes in credit poli­cies. For exam­ple, a com­pany seek­ing to increase mar­ket share may loosen its credit scor­ing cri­te­ria and increase credit avail­abil­ity, yet rec­og­nize that higher loss reserves are required for these new, higher risk customers.

For com­pa­nies with inter­na­tional receiv­ables, dif­fer­ent loss per­cent­ages are typ­i­cally tracked and applied for each coun­try of ori­gin. For com­pa­nies with dif­fer­ent lines of busi­ness or sell­ing across mul­ti­ple indus­try seg­ments, loss fac­tors should be eval­u­ated sep­a­rately for each dis­tin­guish­able cat­e­gory of customer.

Typ­i­cally these approaches are based pri­mar­ily on track­ing his­tor­i­cal results and cal­cu­lat­ing ratios to apply to today’s bal­ances. Losses, whether his­tor­i­cal or prospec­tive, are impacted by other fac­tors, such as the state of the econ­omy or spe­cific industries.

Using regres­sion analy­sis, com­pa­nies can ana­lyze how much his­tor­i­cal losses increased or decreased as gross domes­tic prod­uct growth slowed or improved. This mod­i­fier can then be applied in future peri­ods, when eco­nomic growth changes from a spec­i­fied base level. When ana­lyz­ing their cus­tomers, some com­pa­nies have found that the rate of bank­ruptcy fil­ings is a bet­ter pre­dic­tor of change in loss rates.

Apply­ing his­tor­i­cal loss rates to today’s receiv­ables is not always suf­fi­cient, as con­di­tions may be dra­mat­i­cally dif­fer­ent going for­ward from what hap­pened in the past. When look­ing towards the cur­rent reces­sion, the first in a decade, many com­pa­nies rec­og­nized that their his­tor­i­cal loss per­cent­ages could not accu­rately reflect likely losses in an eco­nomic down­turn. Per­haps their loss per­cent­ages didn’t include data from the last reces­sion, or their busi­ness and/or cus­tomer mix had changed dra­mat­i­cally since the last reces­sion. This sce­nario requires finan­cial exec­u­tives to project the impact of reces­sion on their cus­tomer base and increase the loss fac­tors accordingly.

Exec­u­tives must also be aware of other cur­rent events that could affect losses in ways not cap­tured by his­tor­i­cal data, such as the 9–11 ter­ror­ist attacks or the tech­nol­ogy indus­try melt­down. For exam­ple, com­pa­nies with expo­sure to cus­tomers depen­dent upon air travel and tourism to gen­er­ate rev­enues were likely to see increased losses from these cus­tomers. In addi­tion, over 800 tech­nol­ogy com­pa­nies ceased oper­at­ing, gen­er­at­ing increased losses for their vendors.

Exam­in­ing Spe­cific Accounts
While apply­ing per­cent­ages based on past expe­ri­ence pro­vides a math­e­mat­i­cal answer, most com­pa­nies and audi­tors want to review spe­cific accounts. Audi­tors typ­i­cally look at all large bal­ances (“large” is rel­a­tive to the com­pany), as a loss on one sin­gle account could have a dra­matic impact on receiv­ables losses and reserves. Cred­i­tors may have spe­cific infor­ma­tion on accounts with older bal­ances or on those in lit­i­ga­tion, col­lec­tion, or bank­ruptcy, that indi­cate the stan­dard loss per­cent­age does not pro­vide a true rep­re­sen­ta­tion of likely losses.

A Les­son From Henry Ford
Henry Ford vis­ited junk­yard after junk­yard, inspect­ing Fords that were no longer on the road. This helped him iden­tify parts that were always worn-out, indi­cat­ing that bet­ter exe­cu­tion on these parts could increase future cus­tomer sat­is­fac­tion. But he wasn’t look­ing only for what was bro­ken, but what wasn’t. He fig­ured that a part that was almost always in per­fect work­ing order on scrapped cars was a part made too well, pro­vid­ing an oppor­tu­nity to make it cheaper in the future and save unnec­es­sary costs.

Hav­ing an accu­rate loss reserve is impor­tant for fairly report­ing finan­cial results and gen­er­at­ing share­holder con­fi­dence. Ana­lyz­ing and under­stand­ing his­tor­i­cal losses is a crit­i­cal ele­ment in devel­op­ing good esti­mates. How­ever, there is an addi­tional poten­tial major eco­nomic ben­e­fit from per­form­ing this task, the same as Henry Ford real­ized by vis­it­ing junk­yards. That is the oppor­tu­nity to change future credit grant­ing behav­ior to increase prof­its once his­tor­i­cal results are bet­ter understood.

Dean Kaplan is a Part­ner in Kaplan Group, 805–541-2639