Impairment of accounts receivable on the balance sheet: how to get your bearings

Accounts receivable impairment on the balance sheet is an adjusting item that must be accounted for in order to provide for possible defaults on unpaid receivables from the company's customers.

But the schedule established by tax regulations does not provide a special space for recording these defaults. According to the logic of the accrual principle, in fact, the balance sheet indicates the possibility of realization of a receivable that a customer must pay to the company.

So what are the procedures to be applied in writing down accounts receivable on the balance sheet? What are the different types of receivables subject to write-down? What is the legislation in the tax area that deals with the regulation of the write-down of accounts receivable?

In addition to the allowance for doubtful accounts, why is it important to establish an allowance for doubtful accounts as well?

Are you ready to embark on this long journey with us?

Continue reading then.

See all software Accounting

What is an accounts receivable allowance?

First of all, it is appropriate to establish the basics and understand what a receivable is before venturing into understanding its impairment.

From a legal and judicial point of view, a receivable is the relationship that is established between two parties, a creditor and a debtor, and which stipulates that a sum of money granted by the creditor to the debtor, must be returned according to the terms and timing decided between the parties.

In accounting language, however, these are items that can be found within the balance sheet, in the respective sections of current assets and intangible assets, more specifically at the level of financial fixed assets.

So, it is important to keep in mind that this classification is based on a criterion of origin, namely the difference between a receivable of a financial nature and a receivable of a commercial nature.

Receivables, are subsequently divided into receivables due within the next financial year and receivables due beyond the next financial year.

Receivables of a financial nature are receivables that have turned out to be of a strategic nature, while receivables of a commercial nature are the result of day-to-day operations.

Now that we understand the basics, let's move on to the part that interests us most, which is the write-down of receivables.

The procedure to be followed when writing down receivables at the end of the year

Article 2426 of the Civil Code states in point 8 that:

" receivables shall be recorded at their estimated realizable value."

How, then, is the presumed value of a receivable to be recorded?

The answer lies in the creation of an allowance for doubtful accounts, as the latter is capable of accounting for both already manifest and reasonably foreseeable losses.

Methods of calculation

OIC Number 15 states that the allowance for doubtful accounts should be accounted for by examining:

• Of individual receivables;
• Of any other existing or anticipated facts.

Since they are, as the name indicates, valuations, they are not objective calculations but subjective estimates.

Therefore, as the OIC standard states, they must be based:

" on reasonable assumptions, using all available information, at the time of the valuation, about the situation of the debtors, based on past experience, current general and industry economic conditions, and events occurring after the end of the financial year that affect the values at the date of the financial statements."

To arrive at such a quantification, you have at your disposal two accounting models:

• the analytical method;
• the synthetic method.

The analytical method analyzes the valuation of each individual receivable. The synthetic method, on the other hand, is based on the identification of a lump-sum percentage that is calculated by following specially predefined coefficients.

The analytical method

For the write-down of accounts receivable on the balance sheet, the analytical method is based on two constants:

• the analysis of the receivables one by one and the determination of the assumed losses for each bad debt scenario that has already occurred;
• the estimate to calculate additional unanticipated losses. This factor is based on past experience that has already occurred and other useful elements such as assessment of the seniority of receivables, evaluation of general economic, industry and risk conditions in the country in which the company operates.

The lump-sum method

The alternative to the analytical method is the lump-sum method. This system always used to calculate the impairment of receivables in the balance sheet is used only in some special cases.

Accounts receivable are valued according to the principle of estimation, which is evaluated according to different variations:

• the seniority of past due receivables compared to those of previous years;
• the general economic conditions;
• the specific economic conditions of particular industries or geographical areas.

This method of calculation, however, can only be used to calculate credits:

• of small amounts;
• which behave in a regular manner, without showing anomalies.

Moreover, it cannot result in systematic and continuous use because the benchmarks change each time conditions change.

In fact, this method is rather considered a practical computational system because the correspondence between the applied parameters and the actual conditions is constantly changing.

Regardless of the method, the ultimate goal turns out to be to have losses appear that have a reasonable chance of occurring.

But where should this information be included in the financial statements? Let's look at it together.

Where is the impairment of receivables to be recorded?

Article 246 C.C. No. 8 establishes the outline of the EEC balance sheet does not contemplate, therefore, the recording of receivables is not made according to the value of risk or loss, but according to the possible value of realization.

In the liabilities of the balance sheet, no section appears to indicate the adjustment of the accounts receivable item.

In the income statement, on the other hand, in the section COSTS OF PRODUCTION No. 10 depreciation and amortization, letter d) write-down of receivables included in current assets and cash and cash equivalents, any write-downs and losses of trade receivables can be recorded.

Thus, at the accounting level, the planned write-downs can be recorded in the income statement under cost 10(d) and thus having access to the allowance for doubtful accounts.

However, in order to remain faithful to the financial statement format provided for the balance sheet, when the accounts are to be reported, it will be necessary to enter the allowance for doubtful accounts as a decrease in the accounts receivable item.

The unused allowance for doubtful accounts set aside at the end of an accounting year can be used to cover any losses incurred on receivables in subsequent years.

Why was the allowance for doubtful accounts established in the statutory financial statements?

The CEE financial statement schedule, in its presentation of accounting records, does not include the item of allowance for doubtful accounts.

In fact, until now, the CEE balance sheet format does not provide for the existence, among the liability items, of a specially allocated to the allowance for doubtful accounts. Their accounting entry, therefore, must be made by adhering to the presumed realizable value.

For this reason, the allowance for doubtful accounts was included in the current assets item "Accounts receivable from customers C II 1) on the assets side of the balance sheet of the CEE format balance sheet." And the establishment of the accounting allowance serves to account for the decrease in the value of the item entered as an asset.

Categories of receivables

Trade receivables

In accounting, following a receipt of revenue from the sale of goods or services (typical of a business activity), a trade receivable must be recorded as an offset to follow double-entry rules.

Trade accounts receivable also include all bills of exchange and accounts showing customer defaults.

According to Article 2426 No. 8 of the Civil Code, the company must record accounts receivable at their estimated realizable value in the annual financial statements.

The allowance for doubtful accounts will be the accounting document where trade receivables, which are considered doubtful due to an already verified or highly possible risk, will be grouped.

In order to comply with the general principle of prudence established by corporate accounting, it will be necessary to take into account receivables recorded after the closing of the financial statements that, however, affect prior data.

Other receivables

Apart from trade receivables, it is necessary to mention all other existing receivables that are not classified in this category:

• pledge;
• mortgage;
• surety;

For these receivables, the company must consider:

• the enforcement of the guarantees themselves;
• the valuation of insured claims, which is assessed according to the share of risk not covered by the insurance company.

A further subdivision

Accounting standard OIC No. 15, as we have seen, defines what are the general guidelines for determining the correct value of receivables to be recognized in the financial statements. These guidelines can be used to try to identify various methods or processes for determining the correct allowance for doubtful accounts. We thought, therefore, to try to describe a possible process for evaluating accounts receivable, as a potentially usable model for trading companies.

Accounts receivable from customers can be categorized into three groups:

• accounts receivable from customers with respect to companies for which bad debt situations have already appeared (bankruptcy, composition with creditors, etc.), regardless of whether the receivables are past due or not;
• receivables from customers that are past due and not collected;
• receivables from customers that are not past due.

Receivables in the first category must be analyzed analytically, as the company has accounting data to determine, receivable by receivable, the value of impairment.

Receivables in the second category can be calculated based on the estimation process " based on experience and every other element." For their calculation, either the analytical or lump-sum method can be used. The choice between the two methods will depend on the situation:

• calculation of individual accounts receivable, if the information system allows an adequate assessment of write-downs in each case;
• calculation of homogeneous categories of receivables compared with the time elapsed since the expiration of the agreed deferment.

Receivables in the third category are not yet past due and therefore do not need to be written down, especially if they are receivables from customers whose companies are not in a situation of insolvency. However, even minimal write-downs can be made if, as a result of past experience, a minimal percentage of loss can be calculated.

If the bad debt is part of an already manifested bad debt situation, then a separate analysis will be required.

What factors contribute to the write-down?

The OIC standard states that any other useful factors may be used in calculating the impairment of receivables.

But what are these other useful elements that contribute to the final result?

Usually every company has information systems that are able to produce a record of overdue receivables, divided into equivalent categories according to the time elapsed between maturity and deferral. Here is an explanatory image of the situation:

Next, a write-down percentage must be chosen to be adopted to the accounting balances of the individual equivalent categories.

Once the individual write-downs have been determined, it will be necessary to proceed to their algebraic sum. The result obtained will correspond to the ceiling of the allowance for doubtful accounts, which in the annual financial statements, will represent the presumed realizable value, being the direct reduction of the face value of receivables.

The calculation becomes more complex when establishing the percentages of the allowance for doubtful accounts to be applied to the account balances for the different equivalent categories.

These percentages should follow the following general rule:

The more the time elapsed since maturity increases, the more the probability of collection of the receivable decreases, and therefore the percentage of write-down to be applied will have to be increased.

The percentage increase will also increase based on the historical average default figure on the company's books.

In this image you will find a possible example of write-down rates, calculated on the basis of previous experience.

Please note that the calculation must also analyze those credits that:

• Are covered by collateral such as a lien, mortgage, and surety bond
• Are valued on the basis of enforcement
• Are insured the amount not covered by the association

Legislation on the write-down of accounts receivable

All tax information concerning the write-down of accounts receivable on the balance sheet is summarized in Article Number 106 of the TUIR (Presidential Decree No. 917/86).

In this article, write-downs of accounts receivable on the balance sheet can be deducted for IRES purposes according to a flat rate criterion:

• 0.5 percent of the nominal or acquisition value of receivables recorded in the balance sheet in the case where the maximum deductibility is available or until the total amount of write-downs and provisions has reached 5 percent of the nominal value of receivables recorded in the balance sheet.
• In case the provisions exceed the limit of 5% of the receivables recorded in the balance sheet, the excess cannot be deducted for tax purposes, thus producing an upward change in the single form.

Continuing to analyze this tax law, we can divide the allowance for doubtful accounts into two categories:

• Allowance for doubtful accounts that can be deducted for tax purposes, based on what we have just said about the TUIR article;
• Allowance for doubtful accounts that is not deducted for tax purposes, which takes into account the difference between statutory provisions and deductible provisions, again based on the above article.

Still analyzing the TUIR article, when hedging for future credit losses is performed, the non-deducted bad debt provision causes a negative change in the annual tax return. This tax maneuver is performed so as not to totally lose the portion of the provision not deducted at the time of allocation.

What happens when debt collection becomes doubtful?

Accounts receivable should not be presented in company financial statements according to their face value, but according to what the company believes it can actually collect from its debtors. The principle is to be prudent so as not to fall under an overvaluation of the company's capital.

All this implies, that the value of accounts receivable must be adjusted and adjusted in accounting. Three hypotheses are to be considered:

• The write-off of bad debts;
• the allowance for doubtfulaccounts;
• the allowance for doubtful accounts.

The estimated realizable value of receivables: what is it?

As we made explicit earlier, receivables should not be recorded in the financial statements according to their nominal value.

What does this mean concretely?

Accounts receivable are presented in the company's financial statements, according to the provisions of Article 2426, No. 8 of the Civil Code, at " estimated realizable value." Subsequently, the nominal value of receivables must be adjusted by considering expected losses, discounts, other causes, billing adjustments, etc.

In addition, Article 15 of the OIC stipulates that the face value of receivables must be adjusted " by means of an allowance for doubtful accounts to take into account the possibility that the debtor will not fulfill its contractual commitments in full. The allowance for doubtful accounts adjusts receivables recorded as assets."

What is bad debt write-off?

It is all those receivables that the company a sure it can never collect. In fact, in Italian, when the verb " stralciare" is used, it means "the act of removing or removing an item from a set of it."

Thus, in accounting, the purpose of the write-off process is to implement all the procedures necessary to extinguish a debt.

Generally, this decision is made when the enterprise realizes and is assured that the debtor has become insolvent (judicial liquidation procedures, declaration of bankruptcy, etc.).

The enterprise, for example, makes the write-off when it sees that the debt has been coming due for a long time and that all legal procedures have been taken against the debtor, but to no avail. The company then notes a loss on accounts receivable.

What is the provision for credit risk?

Not all receivables present a risk of default. For this category of receivables, there is no risk of default when they fall due.

However, to keep impeccable accounts, it is advisable to provide for the possibility of a generic default risk.

For this reason, an allowance for doubtful accounts should be established for the portion of receivables that have not been collected and for which insolvency had not been calculated.

For example, you know that each year 2 percent of your customers will not make payment for amounts owed.

The accrual principle requires that the eventual loss be recorded in the current year, even if the defaults occur in the following year or years.

At the double-entry level, we will have the following accounting entries:

• an expense in the debit side of the bad debt account;
• a negative financial change on the debit side of the Accounts Receivable Provision account.

To determine, on the other hand, the value to be written in the above items, the calculation is as follows:

1. you make the sum of the receivables for which there is no highly probable risk of default. In our case, we arrived at an amount of 50,000 euros;
2. the average probability of insolvency of our company is calculated. As we said, it corresponds to 2%. So we make 2% of 50,000 euros;
3. we set up a provision for credit risks that corresponds to the calculated amount. Once the settlement entries are entered, the insolvencies amount to, for example, 4,000 euros. You will need, therefore, to have an allowance for doubtful accounts of 4,000 euros so that the allowance for doubtful accounts assumes the same value. However, if the allowance for doubtful accounts already had a ceiling of 2,000 euros, and the calculated defaults are 4,000 euros, then the allowance for doubtful accounts, and consequently the allowance for doubtful accounts, must correspond to 2,000. Thus, once the adjustment entries are entered, the value of the allowance will rise to 4,000 euros.

How should the allowance for doubtful accounts and the provision for doubtful accounts be used?

To comply with the rules of the accrual principle, the use of these two funds must come into play when there are accounts receivable booked in periods prior to the current one.

In the event that the loss occurs in the current year, this default must be accounted for in the current year.

In the eventual scenario of an insolvency, there are two possible cases:

1. receivable belonging to the current fiscal year: the uncollectible receivable is eliminated and a loss on receivable is recorded.
2. receivable belonging to previous years: the uncollectible receivable is recorded on the provision previously set aside. In this case, three situations are possible:
   1. without the liability provision, the receivable must be entered under "non-existent liability";
   2. if the fund exists and is able to cover the loss in its entirety, the receivable must be entered as a decrease in the value of the previously set aside fund;
   3. if the fund has been established, but is unable to cover the loss in its entirety, the fund in question will cover the receivable up to its maximum limit and the remainder will be shown as a non-existence of liabilities.

See all software Accounting

Guarantee fund to offset uncertainty of tax treatment

The guarantee fund is one of the solutions that a company can use to obtain credit insurance to balance the uncertainty arising from tax treatment. This is a kind of protection that every company should think about doing, because credits are always accompanied by great uncertainty about their repayment.

This type of initiative helps companies offset losses from uncollected receivables, but not only that: it is a perfect aid to identifying and anticipating foreseeable losses, even before they occur.

They guarantee, therefore, to completely eliminate the uncertainty of tax treatment. Given their effectiveness, the costs of such insurance remain acceptable.

At the end of this long overview, do you still have questions on this topic? Given its complexity, let us know your opinion about it in the feedback section in the comments.