Bad-Debt Write Offs

If a debt cannot be collected, a creditor company may want to remove it from the books by writing it off. The simplest way to record and measure bad debt write offs is to keep a log of their amount and the date of the write off. When losses are small in dollar amount and frequency, there may be no reason to record losses in any other form.

Measurement procedures differ with respect to bad-debt recoveries. In some cases, recoveries are deducted from the gross amount of the original loss. In other companies, the gross amount of loss is regarded as the most relevant figure and is never altered. Any bad debt recovery is simply recorded as extraordinary income.

For industry and product line comparisons, losses are generally shown net of recoveries and expressed as a percentage of total sales. Some credit professionals believe that bad debt write offs should be measured only in relation to credit sales. This refinement may not be important if cash sales are a small or constant percentage of total sales. The argument against using only credit sales is that losses occur on other than open account sales. For example, a COD customer may bounce a check.

The bad-debt write off ratio has limitations for inter-period comparisons. Typically, it pairs bad-debt losses of one period with sales of later periods. A considerable delay in the recognition of losses, as frequently happens, may impair the value of the ratio as a measure of the credit department's effectiveness in managing and controlling credit risk. This weakness may be overcome to some extent by using a short write off period and an appropriate moving average for sales. These same considerations must be taken into account in judging the performance of one credit department against others [or against industry norms] on the basis of bad-debt ratios alone.

To give another dimension to write offs, bad-debt losses can be related to the sales that produced the losses. Real differences of opinion are possible on the most appropriate period to be used in tabulating sales for such a comparison, but the measure has the virtue of relating bad-debt losses to the decisions that gave rise to them. The comparison helps management determine whether the original decisions were appropriate in the time period under review. Too often, the volume of sales to a specific customer that ends up in trouble and in collection is forgotten. A bad-debt write off can be incorrectly interpreted as evidence of poor judgment on the part of the credit manager in extending credit to the account.

Generally, companies must write off an account when the probability is zero that the balance due will be collected. Some companies take the write off when collection efforts are first initiated, and others wait until the amount of loss can be determined with some certainty.

Some companies permit partial write off of an account. The fact that an account is in bankruptcy is not sufficient evidence that an amount due is completely uncollectable.

Note: If a customer is not in bankruptcy but is unwilling or unable to pay a debt owed, it may not be worthwhile to pursue a claim where the cost to recover is greater than the amount to be recovered.

Reprinted with the permission of Credit Research Foundation.

Edited by Michael Dennis, author of "Credit and Collection Handbook" available at the NACM Bookstore.