Is your current bad debt allowance reasonable?
Published November 30, 2020
Due to the COVID-19 crisis, many companies expect to report higher-than-normal write-offs of accounts receivable (A/R) in 2020 and possibly beyond. As the year end approaches, businesses need to review their A/R ledgers for stale, uncollectible accounts that should be written off and consider whether their traditional methods of deducting bad debts are still relevant in today’s conditions.
Reporting uncollectible A/R
Under the accrual method of accounting, a company will report A/R on its balance sheet if it extends credit to customers. This asset represents invoices that have been sent to customers but are yet unpaid. Receivables are classified under current assets if a company expects to collect them within a year or the operating cycle, whichever is longer.
Realistically, however, some customers won’t pay their invoices. Companies report bad debts using one of these methods:
Direct write-off method. Companies that don’t follow U.S. Generally Accepted Accounting Principles (GAAP) typically will record write-offs only when a specific account has been deemed uncollectible. This method is prescribed by the federal tax code, plus it’s easy and convenient. However, it fails to match bad debt expense to the period’s sales. It may also overstate the value of A/R on the balance sheet.
Allowance method. Companies turn to the allowance method to properly report revenues and the related expenses in the periods that they were earned and incurred. This method conforms to the matching principle under GAAP. The allowance shows up as a contra-asset to offset receivables on the balance sheet and as bad debt expense to offset sales on the income statement.
Under this method, the company estimates uncollectible accounts as a percentage of sales or total outstanding receivables. Companies base the estimates on such factors as:
- The amount of bad debts in prior periods,
- General economic conditions, and
- Receivables aging.
Some companies also include allowances for returns, unearned discounts and finance charges. Given the current economic stress, your business might have to update its historical strategies for assessing the collectability of its receivables.
Monitoring changes in your customers’ credit risk can help prevent your business from being blindsided by economic distress in your supply chain. If a customer’s credit rating falls to an unacceptable level, you might decide to stop extending credit and accept only cash payments. This can help minimize write-offs from a particular customer before they spiral out of control.
Estimating the allowance
Bad debt allowances are subjective and can be difficult to audit, especially in uncertain economic times. Auditors use several techniques to assess whether the allowance for doubtful accounts appears reasonable. Management can use similar techniques to self-audit the company’s allowance.
An obvious place to begin is the company’s aging schedule. The older a receivable is, the harder it is to collect. In general, once a receivable is four months overdue, collectability is doubtful. However, that benchmark varies based on the industry, the economy, the company’s credit policy and other risk factors.
Some customers may have requested extended payment terms during the COVID-19 crisis, which could cause an increase in older receivables on your company’s aging schedule. If your company’s allowance is based on aging, you may need to consider adjusting your assumptions based on current conditions.
The effectiveness of past estimates can also engender confidence in future estimates. So, when assessing the allowance for bad debt, it can be helpful to compare prior estimates for doubtful accounts with actual bad debt write-offs. Each accounting period, the ratio of bad debts expense to actual write-offs should be close to 1. If you have several periods in which the ratio is lower than 1, it’s a sign that management is low-balling the allowance and overvaluing A/R. Conversely, several periods in which the ratio is higher than 1 may indicate that management has been accumulating an excessive allowance.
Examining fraud risks
Auditors recognize that accounting estimates are subjective and can be used to manipulate earnings. So, when evaluating the allowance for bad debts, they consider whether management is downplaying or postponing write-offs to artificially inflate assets and profits. During the COVID-19 crisis, management may feel excessive pressure from stakeholders to downplay economic distress.
A/R also may be a target for theft. An employee who’s struggling financially might prematurely write off receivables or overbill customers and then divert the subsequent collections to his or her personal bank account. Such scams are often successful, because fraudsters know that most companies are remiss in monitoring old, written-off receivables, especially in periods of high stress and uncertainty.
We can help
During the COVID-19 crisis, many companies have been unable to execute their normal operating activities — and it’s still unclear how long the economic effects of the pandemic will last. If your company extends credit to customers, it’s prudent to reevaluate the adequacy of your bad debt allowance and make a reasonable adjustment to your reserves based on the disruption caused by COVID-19. Contact your CPA for help estimating your allowance.