(1) Definitions: first we have to define some terms:
* Accounts receivable represent amounts owed by customers who have purchased merchandise or services on credit and who have agreed to pay within a specified period or when invoiced.
* Bad debt expenses (synonyms: bad debt expenses) represent customer amounts that are not collectible; Bad debt expenses are estimated and recorded in the balance sheet;
* Cash 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.
* Accounts receivable, net represent the amounts of the original accounts receivable after deductions for bad debt expense and received cash expense (reported on the balance sheet)
(2) Estimate of bad debt expense
The important question is: How to estimate bad debt expenses? We know they will occur, but we can only estimate the amount. Factors such as credit ratings, history of payments to other providers, general economic situation are impacting bad debt expenses. Here 3 methods are being introduced
* Method 1 – Percentage of credit sales: this is a simplified assumption about the collection of all credit sales made during a period. For example, a business may 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 time effect is not considered in a dynamic market: imagine that the assumption was 2% bad debt receivables in strong economic times. With a sudden bump in the economic environment, you begin to determine only retrospectively, that this assumption is invalid, when it turns out that your old good customers cannot pay and you may need to increase the percentage, for example, to 4% from 5%. of bad debts.
* 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% collection), 31-60 days (95% collection), 61-120 days (85% collection), 121-180 days (only 60% collectible). After 180 days, the accounts receivable will be turned over to a collection agency.
This would provide a more accurate forecast over the time period. In a sudden economic downturn, you already recognize after 30 days (first age category) that the estimated collection percentage needs to be adjusted: For accounts receivable aged 0-30 days, the collection percentage can be lowered, for example, 98% to 95%. Analogous to the other percentages for the different age categories: 31 to 60 days (reduction from 95% to 90%), 61 to 120 days (reduction from 85% to 75%) and a reduction of 60% at 50% for the age category. 121 to 180 days.
* Method 3 – Cancellation: The cancellation method would reduce the accounts receivable directly. It takes effect that some customers will not pay. However, it does not include which customer. And, therefore, it is not GAAP.
Once the provision for bad debts is estimated (with method 1 or method 2), the net accounts receivable can be calculated: (Accounts receivable – Bad debt expense). Bad debt expense is hereby a contra asset as it will be subtracted from Assets on the balance sheet.
(3) Cash discounts to encourage prompt payment
Cash discounts can be a method of encouraging customers to make a timely payment. 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 well regarded. 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 convenient to reduce Accounts receivable also for this against asset.
(4) Summary: In an economic recession, the provision for bad debt expense should be adjusted. It will decrease accounts receivable and will have a direct impact on profit and loss. But the sooner you start to adjust your estimation practice, the sooner you will be in a position to report the rally again.