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Allowance for Doubtful (Bad) Debts

Which methodology do you use and why? Risk Method Historical Method Pareto Method Dart Method

Answers

Topic Expert
Keith Perry
Title: Consulting CFO and Business Operations A..
Company: Growth Accelerator
(Consulting CFO and Business Operations Advisor, Growth Accelerator) |

Wayne,

Whenever this comes up, it is always a negotiation with the auditors.
1) You need stable history to use the historical method.
2) You need a good risk-analysis system to use the risk method (eg brought on a new risky client, you should weight that differently)
3) You need enough clients to have a normal distribution (thus the note in audits when you have a few, big clients).

My preference is to use History when it exists.
The fallback is Pareto; figure out the point risks and measure those, which works well when there are a few, big clients.
I've never been comfortable with my own risk-analysis systems as being better than history or pareto...they have been more binary; either the customer gets credit or they don't, or there is some limit. In the former, it is black and white. In the latter it feeds better into a Pareto.

Risk systems are great if you are investing in the data to get good output. Insurance, credit cards, etc are the gold-ish standard of "we actually have an actuary looking at this stuff." I'm simply more comfortable with the other methodologies, but that doesn't mean they're better (even when I do have decent data).

Cheers,

KP

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

Coming from a banking perspective....

Allowance for bad debts should be based on the CONTINUOUS evaluation (ability to pay or probability of default) of EACH and EVERY CLIENT that are past due.

Whether you establish a system of grading/tiers or the assignment of probability of collection/default according to the grading system, it isstill going to be on a PER CLIENT basis.

Furthermore, historical numbers may NOT address present conditions . One may however gleam some perspective as to how clients in a particular grade or tier eventually end up and the assignment a default percentage for this group.

Topic Expert
Patrick Dunne
Title: Chief Financial Officer
Company: Milk Source
(Chief Financial Officer, Milk Source) |

I have always separated the specific reserve from a general reserve. The specific reserve is for those accounts where we see a real risk of payment. For the general reserve we have used the "black motor formula" or an off shoot of this that is based on historical write off percentages.

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

Patrick, can you explain the need for the general reserve when you have already evaluated all your accounts?

Givenson Piard
Title: Director of Accounting
Company: Osborn International
LinkedIn Profile
(Director of Accounting, Osborn International) |

I evaluate ALL customers 90+ days past due to assign a collection risk % from 0% to 100%, plus any customers less than 90+ days past due if I am aware of a particular reason to. That's my specific reserve. To your point, Emerson, I don't particularly believe there is a need for a general reserve at this point, but external auditors just love the two pieces (must be their training); so like Patrick here, I add a general piece, which approximates 3 months worth of my historical write-offs. In the end, the general piece is less than 5% of my total reserve - not worth fighting over on multiple calls with Corporate, then different levels at our external auditor's firm.

A former Big 4 auditor myself...

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

Givenson, when you were a Big 4 auditor, what is YOUR (or your firm's) justification for the general reserve given that you say external auditors love the two pieces?

As a CFO, I (along with the Credit Team...bank setting) go through the process of evaluating each and every account past due to have a more accurate approximation of our eventual bad debts. Bank examiners (and there are several regulatory bodies) and our external auditors find the process acceptable....and we are in the credit business. We may argue/disagree on the percentages assigned on each classification/grade/tier, but not the process/concept. I find the addition of the "general" reserve to be self defeating (the process) even if it is just 5%. I would even venture to think that they WILL cite (favorably or unfavorably) us if we tack on an extra 5% on top of what the process has recommended.

Topic Expert
Patrick Dunne
Title: Chief Financial Officer
Company: Milk Source
(Chief Financial Officer, Milk Source) |

Emerson-There are always accounts that are in the "current bucket" that will turn bad or those accounts that have always paid slow will not be able to pay. A general reserve based on historical write offs (thus the reference to Black Motor Formula) protects you from unreserved write offs.

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

Patrick - so what are your "specific reserves" for? As I have said, I do NOT see the need for the "general" reserve if one already has account "specific" reserves.

I am speaking from my banking experience and I have applied this to other industries that need credit control and allowance.

Writeoffs very rarely happen in an instant. Accounts go through several stages and deteriorate (chance of collectibility) over time. The impairment of the account and it's "collectibility" determines your allowance. Your allowance for a 30 day past due account is going to be significantly lower than say an account under 120 days past due. Your allowance for a client who is just experiencing a temporary cash problem will be significantly lower than say an account that is filing for bankruptcy.

If the company has information on a "current" account that makes it impaired, (say, 28 days prior to missing their payment or their payment is due) then the company should classify said account in the appropriate pool and compute the appropriate allowance.

Having a "general" reserve (the way you describe it) is tantamount to LAYERING which is an inappropriate way of computing for Loan Loss Reserves (at least in the banking industry).

Regarding historical numbers being used as a basis for calculating reserves. You have seen banks crumble because of their reliance on historical ALLL figures and where caught flat footed by the volatility of the market. This is why I do not put heavy emphasis on historical numbers. Your allowance is for a future event and the collectibility of an account also (among others) depends on the future actions of your team.

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