Credit Where Due

Solving the New ADA Puzzle

Calculating credit loss in a way that complies with recent regulations may seem daunting, unless you take a step-by-step approach. BY C. ROBIN SZABO

You may find yourself scratching your head these days over how to calculate your company’s Allowance for Doubtful Accounts (ADA). It’s an estimate of the amount of accounts receivable that will not be paid by customers and is used to improve the accuracy of accrual financial statements and aid in the forecasting of cash collections. Accounting departments calculate the ADA, and the task is usually assigned to the credit manager, since they are most familiar with the customers in their accounts receivable portfolio.

When ADA is recorded at the time of the credit sale, it’s listed in the current asset section of the balance sheet below cash and is generally presented like this: “Accounts receivable, net of allowance of $66,324, $5,197,456.”

In the past, many companies relied solely on historical bad debt data using an incurred loss model to calculate their ADA. This method, while widely used for many years, had its shortcomings. It did not allow for the probability of suspected future losses to be included in the allowance, since those losses had not yet been realized.

This has resulted in issues for users of the financial information who need decision-useful information about the credit risk inherent with financial assets measured at amortized cost, which includes trade accounts receivable. The global financial crisis magnified the shortcomings, resulting in the Financial Accounting Standards Board (FASB) issuing new guidance in 2016 through ASC 326, “Measurement of Credit Losses on Financial Instruments,” and the introduction of the Current Expected Credit Loss (CECL) model.

This model calculates the credit loss over the life of the receivable and has several weighted components: historical loss data, current economic conditions, qualitative factors and a reasonable forecast of future economic conditions. These components, when combined, will yield a more accurate estimate of credit loss. It’s in use now by Securities and Exchange Commission (SEC) filers and will be for non-SEC filers by 2023.

With the new CECL model, credit managers will need to create additional data points and may need the help of other departments within their organization. Working more closely with sales departments will be a must to track new types of customers. If the data needed is not readily available, managers may need to seek enhancements from IT. This new modeling is not an exact science; it will take time to implement and require tweaking before a truly functional template is in place. So, begin now before deadlines approach.

Where to start? With a little of the old and plenty of the new. First the old: credit managers historically have used previous loss data from their aging buckets to calculate an overall percentage for the incurred loss model ADA. This historical information will be part of the new model, but with adjustments.

Now the new: credit managers are required to perform a risk analysis of their accounts receivable portfolio. This involves taking a deeper look at their current, past and future portfolio of credit customers to

determine which ones have similar risk characteristics. Pool similar customers together and assign a loss percentage for each pool. This is where working closely with salespeople is vital as they pursue additional revenue opportunities by either expanding existing advertiser segments or exploring new ones. Since you are modeling for the future, staying abreast of trends in your customer base and the industries they belong to is extremely important. Keep an especially close watch on those customers that represent the biggest dollars or are a high concentration risk. If you have credit-scoring models in place or subscribe to an organization that provides one (like BCCA), this can be a big benefit. As your customer base evolves, these tools supply quick decision- making information. This new modeling is not an exact science; it will take time to implement and require tweaking After completing your risk analysis, factor in current economic conditions locally, nationally and before a truly functional template is in place. globally. Take into consideration a growing economy versus a slowing economy; qualitative factors; severe weather; supply shortages; pandemics; reasonable forecasts of future economic conditions; inflation; interest rates; and employment. Combining these new data points and applying their influences to historical percentages provides an adjusted overall percentage that can be used to calculate the CECL allowance for trade accounts receivable. CECL implementation may seem daunting, but by taking a step-by-step planned approach, this new modeling will provide more accurate and decision-useful information. C. Robin Szabo is president of Szabo Associates Inc., media collection professionals, in Atlanta, GA. He can be contacted at robin@szabo.com or (404) 266-2464.