Business Transaction

1.1 – Account Receivable(AR)
(AR and Management Policy: Theory and Evidence – Shehzad L. Mian & Clifford W. Smith, Jr)

The basis of my subject “Bad debt expense estimation model” stems from account receivable. Account receivable is the term used by companies to describe money owed to them by clients or customers for goods and services provided. Bad debt expense is that portion of account receivables that will not be collected. Therefore, without any receivables a company will not have bad debts, thus no need to estimate any bad debt expense.

Business to business transactions are mostly done with a promise to pay for goods and services provided at a later date. When a company sells its products or provides its services to other businesses or even individuals, it expects payment for the products or services. In most cases, these payments are not done immediately. The company then expects payment at some future date. This promise to pay becomes a receivable to the company providing the goods or services.

It might not always be the case, but companies want to grant credit to other companies that are financially sound in order to have a greater degree of certainty that payment will be received in the future. Thus, it becomes absolutely important to grade companies and even financial institutions with regards to their payment behaviors. Companies definitely do not want to write off a big part of their assets at the end of the year as bad debt expense.

Generally, there are two main types of trade account receivable. -Current AR
-Past due AR

Current AR are debts that have not yet exceeded the amount of time allocated for the debt to be paid as agreed upon by the creditor and the debtor. In most cases, the length of time for the payment of a debt ranges from ten(10) to as long as ninety(90) days and even to a year in rear cases. This length of time could be longer for specific debts like notes receivable(loan related) issued by companies.

Past due debts are those that have not been paid within the agreed payment term. These are the ones that mostly draw the attention of managers and credit professionals. This is because, the longer a debt is past due, the greater the chances of a debtor defaulting on the payment of the debt.

Managing account receivable has always been a daunting task for managers and other finance professionals. Each organization has its unique operating characteristics and this also calls for different techniques and ways of managing AR. Nonetheless, the foundation behind AR is the policy and procedure for granting credit of the organization. Most organizations obviously want to increase their sales, but the policies they use to assess clients to whom they extend credit will ultimately determine the size of their receivables and to a greater extent, the size of the allowance for bad debt and bad debt expense.

Thus, the credit policies an organization uses will determine the amount of receivables which they need to achieve at any given time. A credit policy is a key financial management guideline that should be prepared under the guidance of top finance managers and accountants. It should incorporate the company’s goal, the criteria and timetable of achieving these goals as they relate to credit functions and the type of accounts/clients that would be required to generate liquidity. Changes in business or economic environment sometimes require that credit policies be readjusted to cope with these changes. Some flexibility must be written into any credit policy to avoid adverse effects of over or too less rigidity.

Different organizations adapt different credit policies. Basically, there are three credit policies and they include restrictive, moderate and liberal credit policies.

1 – Restrictive/conservative credit Policy

This is a very conservative outlook on lending credit to potential customers. Companies that adopt this kind of credit policy mostly deal with only well established customers and customers that pay within terms of payment. The company is unwilling to take risks that are more than minor, preferring to do business with customers that are financially stable. Most companies adopting this policy are invariably in solid financial position themselves and would want to maintain this status quo. Most of them survive even long after more aggressive companies have failed. These companies do not have the need to make any estimate for bad debt expense or allowance since they will have almost no client defaulting on their debts.

However, this policy of conservatism is not without its own inherent risks. It can stifle the growth and cash flow of the company to dangerous levels. The company becomes less competitive and potential customers become reluctant to do business with it. Receivables could reduce drastically since tough credit policies hinder the rapid replacement of old customers or customers that have gone out of business.

2 – Moderate credit(Middle-of-the-road) policy

Companies adopting this policy generally extend credit to good customers as well as to average customers. It strives to find a healthy mix of customers that would both support company growth prospects as well as minimize risks of default. Most companies fall under this category with regard to their credit policies. These companies would tolerate late payments to an extent, they would mostly extend discounts to encourage risky customers to pay within agreed payment terms. They would also require bank guarantees to monitor cash flow and risks of default while attracting more customers.

These companies do have a greater need to estimate bad debt expense and allowance since they do make risky sales that will result to nonpayment at the end of the period. Thus, by virtue of their moderate credit policy, they expect to write off some part of their receivables as bad debt. Applied Materials Europe B.V. is a good example of a company that adopts such a policy.

3 – Liberal credit policy

This is the most dangerous of the three policies. Companies adopting this kind of policy are high risk takers in every area of their operation, mostly with the aim of propelling sales and company growth. They expand much too rapidly for the size and worth of the company, and this often indicates accepting customers that are not financially stable enough for the credit line they receive. The loss of receivables can be heavy and the danger to the company’s survival can be real. Liberal credit grantors are frequently incapable of handling any major loss due to customer defaulting their payments. In addition, undercapitalization and sporadic cash flows may afflict these companies with liberal credit policies. The companies may find themselves not being able to financially accommodate their rapid growth due to insufficient capital brought about by the loss of receivables and sporadic cash flows.

These companies, more than others, have to have a robust model in place for estimating their bad debt expense and allowance since payment default probability from their clients will be high and it will happen frequently. It will not be surprising that companies like these will have a high percentage of their receivables written off as bad debt at the end of the period .

1.2 – Bad Debt Expense and Bad Debt Allowance(Allowance for Doubtful Accounts)

Bad debt expense is that amount of money which a company is unable to collect from its debtors. This is regarded as an expense because it comes as a cost to the company. It is as a result of doing business with other companies that this cost/loss is incurred. This amount is periodically written off from the client’s account especially when the client goes bankrupt or when the company thinks that the cost of pursuing this client for payment will outweigh what is due by the client.

At this stage, the amount owed by the client is credited in the client’s account to remove the balance due. Depending on the accounting system used by the company, the account that is debited is the “allowance for doubtful account”. Or, the write off could be done by debiting the bad debt expense account and crediting the allowance for bad debt(doubtful) account. Being an expense, bad debt expense is usually recorded on the income statement of the company since it affects revenue or sales.

Bad Debt Allowance or Allowance for Doubtful Account(these account names mean one and the same thing and could be used interchangeably) is a balance sheet account. When a company is in doubt that a particular client will not pay, the company will record the amount owed to it by this client in this special account. This is a contra asset account that reduces the account receivable account. This account is adjusted periodically with current estimated amounts and it is from this account that write offs are made in conjunction to bad debt expense.

The Financial Accounting Standard Board(FASB) Accounting Standard Codification(ASC) 310-10-35-7 through 310-10-35-9 requires companies to account for these losses from uncollectible receivables when it is probable that the asset(account receivable) will not be collected and when this amount can be reasonably estimated. The allowance balance is subtracted from account receivable to get the “net accounts receivable” as shown on the balance sheet of most companies.

The amount in the “net accounts receivable” accounts is a more realistic figure of receivables since this takes into account the uncollectible.