(1) Definitions – We have to define some terms first:
* Accounts Receivable represent amounts due from customers who have purchased merchandise or services on credit and who have agreed to pay within a specified period or when billed
* Bad debts expense (synonyms: uncollectible accounts expense) represent amounts from customers who are not collectible; The bad debts expenses are estimated and recorded in the balance sheet;
* Cash discounts represent amounts which can be deducted from their customers if the bill is paid within a stated period (e.g. within 10 days; 2% deduction); These discounts are recorded in the income statement;
* Valuation adjustment is the record to reduce the carrying value of the accounts receivable and recognize the bad debts expense
* Net Accounts Receivable represents the amounts of the original accounts receivable after the deductions of the bad debts expense and expenses from cash received (reported in the Balance Sheet)
(2) Estimating the Bad debts expense
The significant question is: How to estimate the Bad debts expenses? We know, that they will occur, but we can only estimate the amount. Factors like credit ratings, history of payments to other suppliers, general economic situation are impacting the Bad debts expenses. 3 methods are being introduced here
* Method 1 – Percentage of credit sales: This is a simplified assumption about the collectibility of all credit sales made during a period. For example: A company may estimate based on their experience in the past, that 95% of their accounts receivable are collectible. The advantage of this method is it’s simplicity. The major disadvantage is, that the time effect in a dynamic market is not considered: Just imagine that the assumption was 2% of uncollectible accounts receivable in economic strong times. With a sudden slam of the economic environment, you start to determine only a posteriori, that this assumption is not valid, when it turns out, that your former good customers can not afford and you might need to increase the percentage to e.g. 4% of 5% of uncollectible accounts.
* Method 2 – Aging of receivables: Therefore other companies also take the time into consideration. E.g. 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% collectible). After 180 days accounts receivable will be turned over to a collection agency.
This would give more accurate forecast over the time period. In a sudden economic downturn you recognize already after 30 days (first age category) that the estimated collection percentage must be adjusted: For accounts receivable aged between 0 and 30 days the percentage collectible can be reduced e.g. from 98% to 95%. Analog 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 – Write-Off: The write-off method would reduce the accounts receivable directly. It takes into effect, that some customers will not pay. However, it does not include which customer. And there fore it is non-GAAP.
Once the bad debts allowance is estimated (with either method 1 or method 2) the Net accounts receivable can be calculated: (Accounts Receivable – Bad debts expense). The bad debts expense is hereby a contra asset, as it will be subtracted from the Assets on the balance sheet.
(3) Cash Discounts to encourage prompt payment
Cash Discounts can be a method to encourage customers for prompt payment. For example the customer receives a discount of 2% when he is paying the invoice within 10 days. Earning 2% within 10 day is a high rate of return and therefore normally well considered. On the other hand, it leads to significant costs to the seller. The amount for cash discount allowance can also be estimated. Once estimated, it is appropriate to reduce the Accounts receivable also by this contra asset.
(4) Summary: In an economic downturn, the allowance for bad debts expense must be adjusted. It will decrease the Accounts receivable and will have a direct impact on profit and loss. But the earlier you start to adjust the estimation practice, the sooner you will be in the position to report the upturn again.