AGA Today
Federal Accounting Corner
Automating Allowance for Doubtful
Accounts
The process to assess and revise the
allowance for doubtful accounts is cumbersome and memory-intensive.
Agencies must take care when automating this process to maintain
functional integrity.
Allowance for Loss Accounting Entries
When an agency recognizes revenue or a
reduction to expenses associated with a receivable, the matching
principle requires that the agency also recognize a potential expense
(contra-revenue for nonexchange revenues) for any loss due to the
debtor's lack of creditworthiness. The account that offsets accounts
receivable, to reduce it to its anticipated value, is 1319 Allowance for
Loss on Accounts Receivable (similar accounts exist for allowance on
interest, loans, fees and taxes receivable). The Standard General Ledger
(SGL) transactions associated with this account are:
Allow for bad debts: dr. 6720 Bad
Debt Expense
D404 cr. 1319 Allowance for
Loss on Accounts Receivable
Write off bad debts: dr. 1319
Allowance for Loss on Accounts Receivable
D408 cr. 1310 Accounts
Receivable
If no allowance is accrued, then bad
debts are written off using the direct write-off method:
Direct write-off: dr. 6720
Bad Debt Expense
cr. 1310 Accounts Receivable
Allowance for Loss Process
The allowance recognizes bad debt
expenses, which must be matched against current revenues. An entity
could record this simply as a percent of the revenues, or it can assess
a different percentage based on the age of the debt or financial
strength of the debtor. Traditionally, this accrual was made at the end
of the year, so the bad debt expense only showed up in the annual
statements and the allowance for doubtful accounts fell during the year
as it absorbed write-offs, then jumped at the end of the year when the
new assessment was made. The allowance would be adjusted if, at any
time, either the allowance exceeded the outstanding accounts receivable,
or the allowance went negative/debit.
If an entity has a lot small
receivables, it can accurately estimate the allowance based on revenue.
If the receivables are diverse, then it is necessary to group them into
cohorts and assess bad debts expense against each cohort. Normally, the
assessment has a memory. If an agency extends credit to a cohort for
$100,000 and estimates 2 percent is uncollectible, then the initial
allowance is $2,000. As the cohort ages, some debts are defaulted while
most are collected. As debtors default, the agency writes off the bad
debt by reducing the allowance. If, in our example, the debt is for a
short term, after one year we may have collected $97,500 and written off
$1,800 with $700 outstanding. Since the allowance is now $2,000 initial
assessment - $1,800 write offs = $200, the 2 percent estimate has now
evolved into a 29 percent estimate. If the agency collects the remaining
$700, then it should back out the allowance accrual for $200, while if
the agency writes off the remaining $700, then it should first increase
the allowance accrual by an additional $500.
Automating the Process
An ideal attribute of a process to be
automated is that it should have no memory. In other words, the tool
should not have to analyze a long history, but look solely at the
current status. So an automated tool that assesses the allowance for
doubtful accounts would ideally be set up to back out the prior
assessment, look at outstanding receivables, assess the allowance as a
percent of each age group or cohort, and book the new amount. An
automated tool could be run monthly to keep the allowance current, so we
would avoid the problems of having the allowance go negative or exceed
the outstanding receivable. However, if the tool only looks at open
receivables, it will ignore those written off during the year, which
will require the agency to book write-offs directly against Bad Debt
Expense. In our example above, when we start the year with $100,000 and
2 percent default rate, the tool will post $2,000 to bad debts and the
allowance. At year-end when we have $700 outstanding and, assuming a
default rate of 30 percent for year-old debt, the process will back out
the $2,000 assessment and instead record bad debts and allowance of
$210. However, we already wrote off $1,800. So the write-off will have
to increase Bad Debt Expense just as if we were using the direct
write-off method. In that way, the bad debt expense will be $1800
write-off + $210 accrual = $2010, while the outstanding receivable is
$700 and the allowance is $210.
The percentage that is applied to the
outstanding receivables has to take into account not only the age of the
debt (the longer a debt is overdue, the more likely it will never be
collected), but also how aggressively the agency writes off overdue
debt. Say we are six months into the year and we have $10,000 open
receivables and the expected default rate is 10 percent. If we run the
assessment tool, it will accrue $1,000 bad debt. Suppose we write off
$500, and that this has no effect on our assessment of the
collectibility of the remaining $9,500. If we run the assessment tool
with the original default rate, bad debts expense will be $500 for the
write-off plus $950 estimate for a total of $1450. Since writing off the
debt should not increase bad debts expense, the default rate should be
lowered to close to 5 percent.
Conclusion
Calculating the Allowance for Doubtful
Accounts and Bad Debt Expense is not simply a matter of applying a
standard percentage against outstanding debt or against revenue.
Collecting debt reduces the outstanding receivable and increases the
risky nature of the remaining receivables, whereas writing off debt
reduces the outstanding receivable and decreases the risk that remaining
receivables will default. Also, Bad Debt Expense is composed of both the
allowance accrual and actual write-offs. — Simcha Kuritzky, CGFM CPA
This column is provided as part of a
free exchange of ideas in federal accounting, and is not reviewed
substantively before publication. Please send all comments, queries, or
corrections to
Simcha.Kuritzky@CGIFederal.com.