Instructor Blog - Financial Analysis

Q: It was mentioned that the “Bad Debt Expense” on the income statement and the “Allowance For Bad Debt” on the balance sheet are both based on management estimates. Therefore, it was stated, the “Bad Debt Expense” on the income statement is a non-cash item (as it does not represent a cash outflow for the period). How would one go about ultimately determining the true cash outflow from bad debt written off in any given period? If “Allowance For Bad Debt” on the balance sheet is also based on a management estimate then the changes in that account YOY wouldn’t represent a cash change for the company either, correct? Is the only way to know the true cash outflow from bad debt written off to ask the company directly what their actual write offs in any given year were? Could tax returns provide a solution? Great webinar BTW. Some great points were brought up in analyzing both companies.

A: If a company's financial statements include both the Allowance for Doubtful Accounts as an offset to Accounts Receivable on its balance sheet as well as provide a dollar amount for Bad Debt Expense on its income statement, then we can compute the actual write-off amount.

For example, Cardiology Medical Group's 2014 balance in the Allowance for Doubtful Accounts was $1,706,871. In 2015 it added to that balance by the amount of its 2015 bad debt expense of $570,118. That is, it debited Bad Debt Expense, which flows to its income statement, and credited Allowance for Doubtful Accounts by $570,118 which increased the balance from $1,706,871 to $2,276,989. Yet the 2015 Allowance for Doubtful Accounts was $1,742,826. That means that the Group removed $534,163, or $2,276,989 - $1,742,826, from the Allowance balance by writing off that amount of accounts receivable. It did so via a $534,163 debit entry to Allowance for Doubtful Accounts, which reduced that balance by $534,163, and a $534,163 credit entry to Accounts Receivable, which reduced that balance by $534,163.

Interestingly, the company's 2014 Bad Debt Expense was $807,847, It expected to write off that amount of accounts receivable in the near future - likely throughout much of 2015. Yet it only wrote off $534,163, which suggests that it had overestimated the extent of 2014 bad debts or had done an admirable job in collecting receivables - both of which are positive events.

Sometimes the financial statements will include a footnote that specifically states the write-off in the year or years in question. Not so in this instance.

With respect to Buckeye Beverages, there is no Allowance for Doubtful Accounts on the balance sheet and no Bad Debt Expense on the income statements. Further, Footnote 3 states that all accounts are fully collectible. It would be prudent to take this statement with a grain of salt and ask the client if, in fact, it had no write-offs in either 2014 or 2015.

The business income tax returns do provide write-off information. At Line 10 on Schedule 1120S and at Line 12 on Schedule 1065 (the quasi income statements for a Subchapter S corporation and Partnership, respectively), a company reports its Bad Debt Expense under the IRS guidance to "...enter the total debts that became worthless in whole or in part during the tax year..." In other words, enter the amount of accounts receivable (debts) that the company wrote off as uncollectible during the tax year.