Trade Debtors as the Basis. The use of trade debtors as a base is obvious because it represents the uncollected charges from which alone can any loss from bad debts arise. The use of such a base seems correct in principle. This is so in cases where a balance sheet is made up only once a year, so that conditions as to the periodicity of the sales are practically the same from year to year. The amount of loss from uncollectible items is then somewhat nearly proportional to the amount of claims outstanding at the close of the fiscal year. But where it is necessary to make the estimate monthly, or oftener than once a year, it is very probable that at some of the intermediate periods the amount of outstanding claims will bear no logical relation to the loss from bad debts. Thus, in the garment industry the sales for practically the whole year are made within a few months, and during the other months the processes of manufacture and collection are carried on. For these reasons the amount of bad debts is not proportional to the outstanding claims at the end of each month, nor does such a base properly allocate the losses to the periods in which the sales are made. Accordingly one of the two other methods previously mentioned is used.
Sales as the Basis. Inasmuch as there cannot be any loss from bad debts in the cash sales, theoretically the credit sales provide the proper base for making the estimate. Practically, total sales, either gross or net, furnish the base most frequently employed because the total is always available without the necessity for analysis. So long as the ratio of the two kinds of sales remains fairly constant, the loss from bad debts does bear a direct relation to total sales.
Summary. It may be said with respect to the use of trade debtors as a base, that it gives satisfactory results where conditions are uniform from period to period. In its use, however, cognizance must be taken of any change in the credit policy of the business whereby the term of credit is shortened or lengthened as that in itself would tend to change the ratio of the base to the estimated loss from uncollectible items. As between credit and total sales, theory favors the former but practical considerations the latter. If for any reason the ratio of cash to credit sales should change, the change would have to be taken into consideration when making a comparison between periods of the loss from bad debts. No justification can be found for a fourth method sometimes met with, which makes the provision for bad debts bear some relation to the net profits—large if profits are large, and small or none if profits are small.
In handling the estimate of bad debts on the books, the same considerations are to be observed as in booking depreciation. Care must be exercised not to allow the reserve to grow beyond liberally estimated requirements and so create a secret reserve, nor to fall below such requirements. This must be watched closely and, if need be, the rate changed to accomplish the desired result.
Discounts and Collection Costs
In connection with the valuation of trade debtors, the problem of collection costs and cash discounts must be considered. Some authorities connect these costs directly with sales and make provision for them in the valuation of the current trade debtors; i.e., an estimate of the cost of collecting the outstanding claims and of the probable amount of loss from discounts on the amounts outstanding is deducted by means of reserves from trade debtors and so shown on the balance sheet. Where such a practice is followed, strict consistency would require that a similar credit provision be made for discounts on purchases—a practice not often advocated. The weight of opinion is in favor of taking all such costs and credits into account only when they are actually met. This accords with the treatment of these items as financial management items (explained in Volume I, Chapter XXXVI) and as therefore bearing no direct relation to sales. If, however, unusual costs of this or any other kind are anticipated, prudence demands that provision, by means of reserves, be made for them. Usually the costs average up pretty well from period to period.
Valuation of Other Receivable Items on Open Account
The problem of valuing the other classes of receivable items previously mentioned on page 215, does not differ in the main from that of trade debtors just discussed. If they are worth their face value they should be so shown. If worth less, the necessary valuation reserves should be set up. With these items the chief problem, however, is their proper showing on the balance sheet; i.e., their correct classification and a suitable nomenclature. Most of the items are not strictly current, but even their inclusion under this head is not misleading if they are carefully earmarked to show their true nature. Some of them are decidedly fixed, some are in no sense assets. In some cases even trade debtor balances as carried on the books are not strictly current. In concerns where sales are made on an instalment basis, usually the payments extend over several months and oftentimes years. The customer is charged with the whole amount and credited with the regular instalment payments as made. The portion of the outstanding balance covered by the more remote payments is thus not current. In concerns where both regular and instalment sales take place, a separation of the customers’ balances on the basis of the sales contract gives the necessary information for balance sheet purposes. The accounts of instalment trade debtors normally require a much more liberal valuation reserve than those of regular credit customers.
Loss on Notes Receivable
In some cases the expected loss because of uncollectible notes may be less than that from open accounts, due to the greater formality of the note as an instrument of credit and the probably greater loss of credit to the maker in case of dishonor. However, in making provision for bad debts, the practice is almost universal to class the two receivable items together. Such practice is undoubtedly sound. In the case of notes, the request for payment is more forceable because of the definitely stated due date and the loss of standing if unpaid after such date. In some cases the payment of notes is not pressed, nor is any extraordinary provision made for past-due items—as in industries allied with farming when an unusually bad season makes impossible the payment of notes given by farmers. Again, the practice is sometimes made of taking notes for a long overdue, open account. These have usually no better value than the accounts and must be treated accordingly.