current economic crisis timeline
current economic crisis timeline
Matching Receivables: How to Account for Bad Debt
Accounts receivable represent amounts due from customers who have purchased merchandise on credit and who have agreed to pay within a specified period or when billed by a company. Since all accounts receivable represent a portion of purchased merchandise on credit it is a given that some of the income represented within the account will not actually be received by the company. Due to this business phenomenon it becomes necessary for any company to account for this loss on the balance sheet. Commonly named bad debts expense this has become a major focal point in recent financial history because of the credit crisis in the subprime mortgage industry. For companies that issued subprime mortgages there is an internal assumption that a large portion of the accounts receivable or credit debt will not be repaid. The reason a company can handle such a large amount of risk is due to overall sales volume. By having a large clientele base revenues can be increased enough to cover the overall loss, but as recent history shows one shift in the current economic climate can have drastic consequences to not just one industry but to the global economy depending on how leveraged the world economy is to any one economic environment. In the case of the US mortgage market we found that it was not only the mortgage companies but all of the subsidiary investors which took on a portion of the risk by chasing large rewards, these risks created an overly leveraged market. As investors continued to build housing in the hope of riding increases in housing prices they created an excess in housing inventory, which in turn devalued the houses on the market as well as those being built. When localized household wealth declined mortgage lenders lost capital and the ability to fund refinancing and the necessity for an increase in the adjustable rates on existing home loans. Since there was already too much risk inherent in the market those borrowers who were questionable to begin with defaulted at an ever increasing rate until the market collapsed around them. These defaulted borrowers have to be accounted for on the books, and this is what we will take a closer look at.
When a purchaser buys merchandise on credit certain entries must be made to the accounting ledger. Let’s say NEC Inc. sells some coffee cups on credit. If we assume the cups were already produced and in inventory then Cost of Goods Sold (COGS) is debited for the manufacturing cost and Inventory is credited for the same amount, say 7,000 dollars. This takes care of the internal cost of producing those cups. Next Accounts Receivable is debited $10,000 and the Sales account is credited $10,000. Now NEC Inc. has transferred the COGS to the customer but instead of increasing cash flow it has only increased the money owed in the form of accounts receivable. Like your average consumer credit card when goods or services are sold from one company to another some form of payment timeline is agreed to, but for ease of use we will assume the retailer who purchase the cups agreed to pay the total amount in full that the end of the month. However, just few days later a natural disaster strikes and not only is the retailer completely destroyed but all possible liable parties are affected to the point where they cannot pay their debts. Now NEC Inc. has 10,000 dollars the on the books that should have become cash flow but instead will never be recouped.
In this situation NEC Inc. has very little choice but to move the debt into a Bad Debt Expense account. This type of account is called a contra account in that it is reported as a subtraction on the asset portion of the balance sheet. Under the asset portion of the balance sheet an entry is logged under allowance for bad debts while bad debts expense is debited. This is of course is not a write off, but it is unlikely that a company would write off the debt until the books have been closed that the end of fiscal quarter. When the write-off entry is noted it will come in the form of decrease to the accounts receivable account and an increase to the allowance for bad debt. In the case of NEC Inc. the initial entry would include a debit of -$10,000 to Allowance for Bad Debts and a credit of -$10,000 to Bad Debts Expense. Then debit of -$10,000 to Accounts Receivable and a debit of +$10,000 to the Allowance for Bad Debts. The allowance for bad debts account is a valuation account because its credit balance is subtracted from the debit balance off the Accounts Receivable. If, on the other hand, a company wishes to use the direct write-off method then a debit is entered under Bad Debts Expense and a credit is placed under Accounts Receivable for the amount of the bad debt. By correctly recording bad debt a company ensures that its net income, ROI, ROE, and liquidity measures remain accurate.
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