(1) Definitions – First we need to define some terms:
* Accounts receivable represent amounts owed by customers who purchased merchandise or services on credit and agreed to pay within a specified period or when invoiced.
* Bad debt expense (synonyms: bad debt expense) represents amounts from customers that are not collectible; Bad debt expenses are estimated and recorded on the balance sheet;
* Prompt payment discounts represent amounts that can be deducted from your customers if the invoice is paid within a set period (for example, within 10 days; 2% deduction); These discounts are recorded in the income statement;
* The valuation adjustment is the record to reduce the book value of accounts receivable and recognize the expense for bad debts
* Net Accounts Receivable represents the original accounts receivable amounts after deductions for loan loss expense and cash received expense (reported on the Balance Sheet)
(2) Estimate of the expense for bad debts
The important question is: How to estimate bad debt expenses? We know they will occur, but we can only estimate the number. Factors such as credit ratings, payment history with other providers and the general economic situation are affecting bad debt expenses. 3 methods are being introduced here
* Method 1 – Percentage of Credit Sales: This is a simplified assumption about the collectability of all credit sales made during a period. For example: A company can estimate based on its past experience that 95% of its accounts receivable are collectible. The advantage of this method is its simplicity. The main disadvantage is that the effect of weather is not considered in a dynamic market: imagine the assumption was 2% of uncollectible accounts receivable in strong economic times. With a sudden hit of the economic environment, you begin to determine only after the fact, that this assumption is invalid, when it turns out that your former good customers cannot pay and you may need to increase the percentage to, say, 4% from 5%. of uncollectible accounts.
* Method 2 – Aging of accounts receivable: Therefore, other companies also take time into account. For example, the following age categories (and their estimated collection percentage): 0-30 days (98% collectible), 31-60 days (95% collectible), 61 – 120 days (85% collectible), 121 – 180 days (only 60% collected). After 180 days, accounts receivable will be turned over to a collection agency.
This would give a more accurate forecast over the time period. In a sudden economic downturn, already after 30 days (first age category) recognizes that the estimated collection rate needs to be adjusted: for receivables aged between 0 and 30 days, the collection rate can be reduced, for example , from 98% to 95%. Analogous to the other percentages of the different age categories: 31 – 60 days (reduction from 95% to 90%), 61 – 120 days (reduction from 85% to 75%) and a reduction from 60% to 50% for the age category of 121 – 180 days.
* Method 3 – Cancellation: The cancellation method would reduce the accounts receivable directly. Take in effect, that some customers will not pay. However, it does not include which client. And therefore, it is not GAAP.
Once the allowance for bad debts is estimated (with either method 1 or method 2), the net accounts receivable can be calculated: (Accounts receivable – bad debt expense). The expense for insolvencies is a counter-asset, since it will be subtracted from the Assets on the balance sheet.
(3) Cash discounts to encourage early payment
Early payment discounts can be a method to encourage customers to pay early. For example, the customer receives a 2% discount when he pays the invoice within 10 days. Earning 2% in 10 days is a high rate of return and therefore normally considered fine. On the other hand, it generates significant costs for the seller. The amount of the early payment discount allowance can also be estimated. Once estimated, it is appropriate to reduce Accounts Receivable also for this contraactive.
(4) Summary: In an economic downturn, the provision for bad debt expense must be adjusted. It will decrease Accounts Receivable and will have a direct impact on the profit and loss account. But the sooner you start to adjust your estimation practice, the sooner you will be in a position to report the rally again.
