Introduction to Allowance Accounting
Allowance accounting is an important component of financial accounting and understanding it is essential for anyone conducting financial statement analysis. This accounting technique is often used by companies to anticipate future losses, specifically from receivables that may not be fully collectible, or from goods that may be returned or have their price reduced. A proper understanding of this method not only aids in the accurate representation of a company's financial health, but also helps analysts to evaluate the risk associated with uncollectible accounts.
Allowance accounting, while appearing complex at first glance, can be broken down into simpler concepts which we will explore in detail throughout this blog post. We will investigate the fundamental principles that guide this method, compare it with the direct method of accounting, and introduce some common practices used in allowance accounting.
Role of allowance accounting in financial statement analysis
The impact of allowance accounting extends far beyond just the balance sheet. It affects the portrayal of profitability, liquidity, and risk management strategies of a company, making it an essential tool for financial statement analysis. The adjustments made through allowance accounting can provide insights into the credit risk management of a company, its sales policies, and future cash flow expectations. This post will shed light on how these adjustments should be interpreted and what they mean for a company's financial performance and stability. Understanding this technique equips analysts and investors with the knowledge needed to make informed decisions. Stay tuned as we dive deeper into this fundamental aspect of financial accounting.
Allowance Accounting Basics
Definition and principles
Allowance accounting is a method used to account for potential losses resulting from uncollectible accounts; the most common example is accounts receivable.
Offering credit to customers and vendors and allowing for product returns can generate more revenue for businesses. However, it also introduces financial risks in the form of customers potentially not paying or returning product. To manage these risks and accurately reflect the associated costs, allowance accounting must be employed.
Allowance vs. Direct Method
Businesses face the risk that a customer or vendor may not pay on time or at all. There are two primary methods to account for bad debt:
Direct Method
While the direct method is required for income tax purposes, it is less useful for most stakeholders other than the IRS due to improper matching of expenses to revenues. Although this method is more reliable since companies wait until more accurate values are known, it is less timely and therefore produces less relevant information.
Allowance Method
The allowance method involves estimating and budgeting for an expected amount of bad debt. For many experienced companies, this method provides information in a timely manner. However, it is less reliable for inexperienced companies, businesses in certain industries, or during times of economic volatility.
Common Allowance Methods
Percentage of Sales Method
This method estimates expected losses as a percentage of credit sales made during the period. The rationale behind this is that the more a company sells, the more likely a loss will occur.
Aging Method
The aging method estimates expected losses based on the age of receivables. The longer a company has not been paid, the less likely it is to be paid.
Allowance for Doubtful Accounts (ADA)
The purpose of ADA
Accruing a bad debt expense refers to the process where a business recognizes that some of its customers will not pay for the goods or services they've received on credit.
Under the accrual basis of accounting, revenues are recognized when they are earned (not necessarily when cash is received), and expenses are recognized when they are incurred (not necessarily when cash is paid). In line with this principle, businesses that extend credit to their customers must estimate and recognize the bad debt expense at the same time they record the revenue from the credit sales, even if they haven't yet identified which specific customers will fail to pay.
Bad debt expense is essentially an estimation of the amount of the accounts receivable that customers will never pay. This amount is then recognized as an expense on the income statement. Simultaneously, a contra-asset account, usually called "Allowance for Doubtful Accounts" or "Expectations of Uncollectible Accounts Receivable", is increased on the balance sheet to reduce the net amount of accounts receivable to the amount that is expected to be collected.
This approach adheres to the matching principle, which is a fundamental accounting principle requiring that expenses be matched with revenues in the same period in which the revenues were earned. This way, the revenue from sales on credit is matched with the expense of uncollectible amounts in the same accounting period.
Process for using the ADA Account
The Allowance for Doubtful Accounts (ADA) is written off, or reduced, when a specific account receivable is identified as uncollectible and is therefore removed from the Accounts Receivable balance.
This process involves two steps:
-
Recognition of bad debt expense: At the end of an accounting period, based on past experience and judgement, a company estimates the amount of its accounts receivable that it expects not to collect. The company records this as bad debt expense on the income statement, and simultaneously increases the ADA(XA) contra asset account on the balance sheet. For example, an estimate of $100,000 for the ADA would be accounted for in the balance sheet equation as:
A/R - ADA(XA) = Liabilities + R/E $100,000 -$100,000
Write-off of uncollectible account: When a specific account is identified as uncollectible (for example, if a customer declares bankruptcy), the company will write off that specific amount against the ADA. The entry to write off a bad account affects only balance sheet accounts: the ADA account is decreased and accounts receivable A/R account is also decreased by the same amount. No expense or loss is reported on the income statement because this write-off is "covered" by the amount already reported as Bad Debts Expense or ADA. For example, if an accounts receivable was determined to be uncollectible for the amount of $10,000 then this would be recorded using the balance sheet equation as:
A/R - ADA(XA) = Liabilities + R/E ($10,000) ($10,000)
It's important to understand that the write-off doesn't provide any additional expense, it simply removes the uncollectible amount from Accounts Receivable. The ADA, acting as a contra-asset account to accounts receivable, shows the estimated amount of receivables that the company doesn't expect to collect. This amount is subtracted from accounts receivable, to arrive at the net amount of receivables that the company expects to turn into cash.
Over time, as accounts are written off as uncollectible, the balance in the ADA decreases. The company replenishes this balance, if necessary, in the following accounting period when it again recognizes bad debt expense and increases the ADA.
Net Accounts Receivable
The net accounts receivable is the difference between the gross account receivable and the ending balance of the ADA account. For example, a company at the start of a period that had a beginning balance in ADA of $88,000, budgeted for an additional $200,000 for allowance for doubtful accounts, and over the period wrote off $91,000 from account receivable would have an ending balance in ADA of $197,000.
| ADA | |
|---|---|
| Beginning Balance | $88,000 |
| Additions | $200,000 |
| Write-offs | ($91,000) |
| Ending Balance | $197,000 |
It can be seen that the general formula for determining net accounts receivable is:
\(\text{Beginning Balance} + \text{Additions} - \text{Write-offs} = \text{Ending Balance} \)The additions are commonly referred to as the Bad Debt Expense, because as seen above, when the estimate is made for the amount of debt that will be uncollectible is made, due to accrual accounting it is at that time that the bad debt expense hits the retained earnings. A common mistake made by those new to this concept is to assume write-offs directly impact retained earnings; they do not. As we saw above, write-offs only directly impact the ADA account.
Allowance for doubtful accounts and its impact on financial statements
The allowance for doubtful accounts is an estimate of the amount of accounts receivable that a company believes it may not be able to collect. This estimate is recorded as a contra-asset account, reducing the total accounts receivable reported on the balance sheet. The impact on financial statements includes:
- Balance sheet: The allowance for doubtful accounts is subtracted from the accounts receivable, presenting a more conservative view of the company's assets and their collectibility.
- Income statement: The amount of bad debt expense, which is an estimate of the accounts receivable that will not be collected, is recognized as an expense in the period it is estimated. This reduces the company's net income for that period.
- Cash flow statement: The allowance for doubtful accounts does not impact the cash flow statement directly, as it is a non-cash item. However, it may impact the cash flow from operations if the company has to write off a significant amount of bad debt that exceeds the ADA account balance.
Liability for Return Allowances
The liability for return allowances is a liability account used to budget for potential product returns. This account is analogous to the Allowance for Doubtful Accounts (ADA) but serves as a liability account instead of a contra asset account. The seller must estimate the dollar value of products that will be returned.
When returns actually occur, the company reduces the liability for return allowances account and also reduces the A/R account, reflecting the reversal of the original sale transaction; this has no effect on net income. This approach helps to ensure that the financial statements provide a more accurate representation of the company's net sales and outstanding liabilities related to product returns.
Example: Accounting for expected return of product
Lets go over an example of how a company might account for expected return of product that was shipped to a distributor but later returned. Suppose a company sells shampoo and knows from experience that about 10% of the product that it ships to distributors will be returned. This quarter the company has shipped $2.5 million of product. The company would then record this using the balance sheet equation by recognizing the revenue in retained earnings (R/E), recording in accounts receivable (A/R) the amount that was sold, and then reduce R/E by the amount of the expected returns and increase the Liability for Return Allowances (LFRA) liability account by the expected amount to be returned:
| A/R = | LFRA(L) | + R/E |
|---|---|---|
| $2,500,000 | $2,500,000 | |
| $25,000 | ($25,000) |
In the future after returns have occurred the company would then account or the returns by reducing the LFRA(L) and A/R accounts. For example, if $18,000 in returns occurred over the next quarter then this would be recorded as:
| A/R = | LFRA(L) | + R/E |
|---|---|---|
| ($18,000) | ($18,000) |
Implications for financial statement analysis
Allowance accounting has several implications for financial statement analysis, as it provides insights into the quality of a company's assets and its overall financial strength. Some key implications include:
- Asset quality: By analyzing the allowance for doubtful accounts, analysts can assess the quality of a company's accounts receivable and its likelihood of collecting them, which may impact the company's liquidity and financial stability.
- Management's estimation accuracy: The allowance for doubtful accounts is an estimate, which can be subject to management's judgment. By comparing the actual amount of bad debt write-offs to the allowance, analysts can assess the accuracy of management's estimates and the potential for earnings manipulation.
- Financial ratios: The allowance for doubtful accounts affects various financial ratios, such as the accounts receivable turnover ratio and the debt-to-equity ratio, which can provide insights into the company's efficiency in managing its receivables and its overall financial leverage.
When analyzing financial statements that used allowance accounting, we must:
- Estimate expected bad debts and expected returns.
- Recognize these estimates as revenues are recognized.
- Understand that there is scope for judgment and discretion in making these decisions.
Extracting Information for Quantitative Models
Identifying accruals and allowances in financial statements
To accurately interpret financial statements and extract valuable information, it's crucial to identify accruals and allowances. Some key steps to follow are:
- Review the balance sheet to identify assets and liabilities that result from accrual accounting, such as accounts receivable, accounts payable, and accrued expenses.
- Examine the income statement for revenue and expense recognition patterns to determine if they are based on accrual accounting principles.
- Analyze the notes to financial statements, which often provide insights into the company's accounting policies related to accruals and allowances.
- Look for the allowance for doubtful accounts on the balance sheet or in the notes, which indicates the company's estimation of uncollectible receivables.
Adjusting financial data for accruals and allowances
Once accruals and allowances have been identified, the next step is to adjust the financial data accordingly. Some common adjustments include:
- Calculating the cash flow from operations by removing non-cash items, such as depreciation, amortization, and changes in working capital.
- Adjusting the net income by adding or subtracting accruals and allowances to obtain a more accurate representation of the company's economic performance.
- Reclassifying certain balance sheet items, such as moving the allowance for doubtful accounts from a contra-asset account to a liability account, to better reflect the company's financial position.
Improving the accuracy of machine learning and econometric models
By incorporating accrual and allowance adjustments into financial data, we can improve the accuracy and predictive power of our machine learning and econometric models. Some ways to achieve this include:
- Using adjusted financial data as inputs for models to ensure they are based on a company's true economic activity, rather than distorted by accounting practices.
- Including accrual and allowance-related variables in the feature set, such as the ratio of accruals to total assets, to capture their impact on financial performance and risk.
- Developing specific models to detect earnings manipulation and aggressive accounting practices, which can help to identify potential red flags and mitigate risk.
Accounts Receivable Analysis Ratios
A/R Turnover = \(\frac{\text{Revenue}}{\text{Average Accounts Receivable (net)}}\)
The A/R turnover measures how quickly a company collects cash on credit sales. A larger number indicates faster collection.
Days Receivables = \(\frac{1}{(A/R \thinspace Turnover)} \times 365\)
Days receivable measures the number of days it takes a company to collect payment after a sale. A smaller number indicates faster collections.
Conclusion
Reiterating the importance of understanding allowance accounting
Understanding allowance accounting is crucial for quantitative analysts working in portfolio management companies that use machine learning and econometric models. By incorporating these principles into financial data analysis and model development, investment teams can better assess the financial health, performance, and risk profile of their portfolio holdings. This ultimately leads to more informed and effective investment decisions, which can result in superior risk-adjusted returns.