(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 billed.
* Bad debt expense (synonyms: Bad debt expense) represents customer amounts 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 recording 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 of loan loss expense and cash received expense (reported on the Balance Sheet)
(2) Estimated bad debt expense
The important question is: How to estimate bad debt expenses? We know they will happen, but we can only estimate the number. Factors such as credit ratings, payment history to other providers, 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 may estimate based on 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 time in a dynamic market is not considered: imagine the assumption was 2% of bad receivables in strong economic times. With a sudden shock to the economic environment, you begin to determine only in hindsight that this assumption is invalid, when it turns out that your old good customers can’t pay and you may need to increase the percentage to, say, 4% from 5%. of uncollectible accounts.
* Method 2 – Age 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% chargeable), 31-60 days (95% chargeable), 61 – 120 days (85% chargeable), 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) you recognize that the estimated collection percentage needs to be adjusted: for receivables aged between 0 and 30 days, the collection percentage 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 of 60% to 50% for the age category of 121 – 180 days.
* Method 3 – Write-off: The write-off method would reduce accounts receivable directly. Take in effect, that some customers are not going to pay. However, it does not include which customer. And therefore, it is not GAAP.
Once the provision for doubtful accounts is estimated (either method 1 or method 2), the net accounts receivable can be calculated: (Accounts receivable – bad debt expense). Loan loss expense is a contra asset, as it will be subtracted from Assets on the balance sheet.
(3) Cash discounts to encourage prompt payment
Prompt payment discounts can be a method of encouraging customers to pay promptly. 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 is therefore normally considered fine. On the other hand, it generates significant costs for the seller. The amount of the cash discount allowance can also be estimated. Once estimated, it is necessary to reduce the Accounts receivable also for this contraactive.
(4) Summary: In an economic downturn, the provision for bad debt expense needs to be adjusted. It will decrease Accounts Receivable and will have a direct impact on the profit and loss account. But the sooner you start tightening estimation practice, the sooner you’ll be in a position to report the rally again.