Companies have a fair amount of discretion regarding how they will estimate their losses from customers who fail to pay, and when they will recognize the losses.
When a company records a sale, if it has not yet collected the proceeds it records an account receivable on the balance sheet. Sometimes the company is unable to collect its receivables, and they have to be written off as a bad debt expense. To prepare for this contingency, companies create a reserve account known as the allowance for doubtful accounts, where they estimate how much of their receivables will not be collected and exclude that amount from being recognized on the income statement. If in fact the receivable is not collected it is charged against the reserve account rather than appearing on the income statement at that time. Because the amount reserved in any period is subject to management’s discretion, it is an area that can be used to manipulate earnings. Even when management is completely scrupulous the allowance for doubtful accounts can be an early warning indicator for potential problems.
As noted above, management has some discretion as to how much of a reserve should be taken in a given accounting period. We have discussed similar issues with respect to financial receivables for companies that lease or finance sales to customers. We have also commented in several posts about companies that may be under-reserving their allowance for doubtful accounts. Here we explain how to analyze this account more fully.
Management’s discretion has certain limitations. The amounts recorded in reserve accounts has to be explained to auditors, and generally follow some guidelines. Sometimes it can be a simple percentage of sales or gross accounts receivable that is assumed will not be collected based on prior history. Sometimes the system may be more complicated, as described in the disclosures below, which were taken from Fidelity National Information System’s (FIS) recent 10Q:
Since the Merger with Certegy, the Company recognizes a reserve for estimated losses related to its card issuing business based on historical experience and other relevant factors. The Company records estimates to accrue for losses resulting from transaction processing errors by utilizing a number of systems and procedures in order to minimize such transaction processing errors. Card processing loss reserves are primarily determined by performing a historical analysis of loss experience and considering other factors that could affect that experience in the future. Such factors include the general economy and the credit quality of customers. Once these factors are considered, the Company assesses the reserve adequacy by comparing the recorded reserve to the estimated amount based on an analysis of the current trend changes or specific anticipated future events. Any adjustments are charged to costs of services. These card processing loss reserve amounts are subject to risk that actual losses may be greater than estimates.
In the Company’s check guarantee business, if a guaranteed check presented to a merchant customer is dishonored by the check writer’s bank, the Company reimburses the merchant customer for the check’s face value and pursues collection of the amount from the delinquent check writer. Loss reserves and anticipated recoveries are primarily determined by performing a historical analysis of our check loss and recovery experience and considering other factors that could affect that experience in the future. Such factors include the general economy, the overall industry mix of customer volumes, statistical analysis of check fraud trends within customer volumes, and the quality of returned checks. Once these factors are considered, the Company establishes a rate for check losses that is calculated by dividing the expected check losses by dollar volume processed and a rate for anticipated recoveries that is calculated by dividing the anticipated recoveries by the total amount of related check losses. These rates are then applied against the dollar volume processed and check losses, respectively, each month and charged to cost of revenue. The estimated check returns and recovery amounts are subject to risk that actual amounts returned and recovered may be different than the Company’s estimates.
However, even in these more complicated cases, the investor can compare the current allowance to past results based on a percentage of sales or receivables to gain insight as to trends. If the allowance is rising or falling at a significantly lower rate than sales it should tell the investor to take a closer look and figure out why.
When the amount being reserved is falling as a percentage of sales or receivables, the result is higher net income than there would have been using a consistent reserve percentage. It is easy to see how management might have an incentive to post higher earnings, so frequently this is the focus of investor concern. However, in the case of FIS we see the opposite trend: the allowance increased 51 per cent, compared with a 23 per cent increase in receivables. Sequential rise in sales cannot be determined due to the accounting treatment of the reverse acquisition of Certegy. The higher allowance for doubtful accounts in the period resulted in EPS being $0.02 lower than would have been reported had the allowance stayed at a consistent percentage of total accounts receivable.
There are several possible explanations for a significant increase in the allowance for doubtful accounts relative to sales or receivables:
- Something has changed. This may be the cause for the rise in FIS, as the company acquired Certegy in a reverse merger during the quarter. Certegy’s check guarantee business could very well have a higher incidence of uncollectible receivables than the legacy FIS business. (Note that this may not be a bad thing if the profitability is high enough to offset the higher incidence of bad debt.)
- The company is actually seeing higher than normal losses from uncollectible receivables. This is also possible in the case of FIS, as the allowance is set partially based on an estimate of current trends. Higher than normal levels of uncollectible receivables could be due to just random luck, but could also indicate the company is pursuing higher-risk customers. In the latter case, it would indicate a lower quality to recorded sales and earnings.
- The company is doing well and management wants to set aside reserves for a rainy day. This would be a case of earnings management in which the company has perhaps done better than expected and uses the opportunity to pad reserves in case they want to tap into them in a tougher period.
- The company is doing poorly and wants to take all its lumps and make future performance look better. This is known as taking a big bath. If the company has no chance to make expectations it may want to set aside extra reserves and take a bigger hit today in order to set up easier comparisons in the future. Since FIS has a number of restructuring and merger charges in the current period, as well as the new requirement to expense stock options, this is yet another possible explanation of the rise in the allowance for doubtful accounts.
Investors should call the company or otherwise try to figure out what is behind any large change in the allowance for doubtful accounts relative to sales and/or receivables.