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