Accurate Reporting of Uncollectables Is Critical To the Financial Statement
by Dexter Braff

Your financial statement looks great, but something must be wrong. Even though revenue is stable and profits are solid, you repeatedly need to dip into your credit line to meet daily operating expenses. How can this be?

The problem is often a result of poor accounting for bad debt and other billing allowances. Consider that in accrual based financial statements, revenue is generally reported when billed to match sales with the expenses incurred to produce them. Unfortunately, in the home health care industry, the actual cash collected can be substantially less than what was billed. Accordingly, every time a dollar of revenue is billed in an accrual-based financial statement and less than a dollar of cash is ultimately collected, the resulting income can be overstated.

The solution to this problem does not lie in resorting to cash-based financials, since the volatility in accounts receivable collections can produce statements that poorly represent actual performance. Rather, the solution is to use an appropriate method to account for uncollectable revenue so the financial statement more accurately reflects expected results.

It is important to note that the difference between what is billed and what is collected can be brought about by much more than bad debt. In fact, actual bad debt--in which an accurate bill is unpaid due to neglect or inability to pay--is often a minor contributor to uncollectability. More often, the culprits are contractual allowances, billing errors, and denied or negotiated claims. Since these types of adjustments reduce cash flow and must be accounted for, we will consider them uncollectable accounts.

The most common way to account for uncollectables is the direct write-off method, in which an uncollectable expense is recorded when it is actually determined. For example, a denied claim might be recorded when the payer issues its denial, even though the bill and associated revenue were recorded six months earlier.

Although the direct write-off method is the easiest to use, it is flawed in several ways. First, the expense or cost of the write-off is not matched with the period in which the revenue is recorded. Accordingly, the company overstates income in the period in which the sale occurs and understates income when the write-off is taken. Second, companies can consistently overstate income simply by delaying the write-off. Regardless of whether this is intentional, repeated appeals of denied claims or continued attempts to collect overdue accounts can substantially overstate a company's earnings. Finally, the accounts receivable account of companies using the direct write-off method is always overstated because it does not reflect any adjustment for anticipated write-offs.

Given these shortcomings to the direct write-off method, allowance methods are much preferred. The key difference between the direct write-off and allowance methods is that when an allowance method is used, an assessment of uncollectibality is reported in advance of an actual write-off. The write-off is therefore more closely matched with its associated billing and revenue.

When using an allowance method, the company estimates uncollectable revenue and posts the amount to an appropriate income statement expense account. Unless separate allowance accounts are kept for bad debt and other types of billing adjustments, a general account that provides for uncollectable revenue is typically preferred. Simultaneously, the company records an equivalent adjustment to an accounts receivable allowance account on its balance sheet. The company's best estimate of the collectability of these receivables is thus represented by accounts receivable less the allowance account, or accounts receivable minus net.

By regularly estimating and recording uncollectable allowances, companies can anticipate adjustments as revenue as recorded and receivables age, thereby enhancing the integrity and interpretive value of their financial statements. This is based on the fact that when a receivable is actually written off, the corresponding entry is posted against the accounts receivable allowance account on the balance sheet. Income is not affected, because the write-off reduces both accounts receivable allowance account, resulting in no change in net accounts receivable.

The two basic methods for estimating uncollectable accounts are the percentage of sales method and the aging of accounts receivable method. In the percentage of sales method, the company multiplies total billings by an appropriate percentage, generally based on historical cash collections as a percentage of associated billings. This implies that uncollectable amounts will vary with the amount of billings and that prior collections experience is a reasonable predictor for current billing activity. For example, if the company calculates that it collected 92 percent of billings generated during a six-month period, using the percentage of sales method, the company would record 8 percent of monthly billings as its monthly provision for uncollectable accounts. This method is attractive because of its simplicity in both concept and calculation.

Although somewhat more complicated to calculate than the percentage of sales method, the aging of accounts receivable method is generally more accurate because it more closely relates to current, rather than historical, collections trends. In this method, the company classifies receivables into groups according to the length of time they are past due. Typically these aging categories include 0-30 days, 31-60 days, 61-90 days, 91-120 days, and 121 days and over. Based on experience, the company then estimates the uncollectable amounts separately for each aging classification. As we would anticipate, the older the classification, the greater the anticipated uncollectability.

The aggregate estimate of uncollectability for each age group then represents the total allowance for uncollectable accounts that should be recorded against accounts receivable on the company's balance sheet. Accordingly, the provision for uncollectable accounts booked to the company's income statement for the period is the adjustment necessary to bring the allowance to the required level.

Perhaps more than in any other area, poor accounting for uncollectable revenue can lead to inaccurate financial reporting and, hence, misinformed management decisions. Accordingly, whichever method is chosen, it is critical to rigorously and continuously evaluate and account for uncollectability.

Reprinted from HOMECARE Magazine, May 1997