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Reporting Default Risk and Allowance for Doubtful Accounts

Executives in the construction industry and construction financial managers constantly manage and analyze their company’s working capital. At year end, the company must have its balance sheet right and financials reported accurately according to Generally Accepted Accounting Principles (GAAP).

In order to do this, contractors must understand their company’s overall default risk and write-off exposure and how it hinges on the security position of accounts.

What is a Secured Position?

All construction project participants have the opportunity to secure their receivables. Such security is available through the use of mechanics lien and bond claim rights. Whenever a party preserves such a right, that party is in a “secured position.”

Those unfamiliar with lien and bond claim rights may incorrectly believe their company gets a secured position whenever a lien or bond claim is filed against a project. In fact, companies are in a secured position whenever they are capable of filing a lien or bond claim. Whenever the right is preserved, the collateral is preserved, and as such, the secured position of the company is preserved.

Preserving the security right in most circumstances requires the construction project participant to send a preliminary notice at the start of work. If this is done, the security position is maintained, and the company is considered to be in a secured position. Maintaining a secured position on an account balance changes the nature of the debt. So how does a company’s security position affects the nature of its doubtful accounts forecasting and default risk?

Reporting Bad Debt Allowances

When a company reports its earnings and assets, it must calculate those figures accurately and conservatively. In the world of accounts receivables, this means the company must conservatively forecast the percentage of receivables that ultimately will not be collected. This is typically done by establishing an allowance for doubtful accounts.

For example, if a company has $100,000 of receivables on the books at the close of a fiscal year, it may expect to write off 5 percent of those receivables. In this instance, the firm would report receivables of $95,000 on the balance sheet.

Companies cannot pluck that 5 percent figure out of thin air. GAAP dictates the parameters for calculating this allowance, and it is clear that companies may use one method to measure the allowance figure across all receivables, or they may break their receivables into classes and use multiple methods to measure the allowance.

In a 2010 academic paper published in Bryant University’s Global Perspectives on Accounting Education, Using Judgment to Measure the Allowance for Doubtful Accounts, author Catherine Finger states that while the GAAP may allow multiple calculation methods for reporting bad debts, “accountants must exercise judgment when choosing which method to use” (FN1, p.12).

She goes on to explain, “Accountants…must decide whether different classes of receivables (e.g. receivables with different ages, for different products, and from different classes of customers) exhibit collection patterns that are different enough to justify the use of multiple default rates.”

While the GAAP empowers companies to calculate bad debt using different methods, there is very little regulation around what methods may be used, except to require “conservatism.” However, studies of companies that prioritize their security rights have found secured accounts receivables consistently outperform unsecured receivables.

Therefore, segregating these two classes of receivables and applying a different allowance would be an acceptable multi-method calculation of bad debt, and likely would result in increasing and making more accurate the earnings reported by companies.

Default Risk With Secured Accounts Receivables

Default risk, also frequently referred to as credit risk, is the risk a company will sustain losses as the result of its customers not paying their bills. Default risk is typically reported by a company within its annual reports (if it is publicly traded or reporting to private investors).

If a company has one customer, its default or credit risk is quite high because that one customer holds the entire company’s fate in its hands. Companies with a broad customer base face a significantly lower default risk.

Consider the default risk reported by Grainger in its 2013 annual report: “The company has a broad customer base representing many diverse industries doing business in all regions of the United States, Canada, Europe, Asia and Latin America. Consequently, no significant concentration of credit risk is considered to exist.” Notwithstanding this disclaimer of localized credit risk, in the aggregate, it is clear that companies with broad client bases have at least a mentionable credit and default risk.

From 2007 to 2009, during the economic downturn, Grainger reported a 2.06 percent allowance, meaning that it expected 2.06 percent of its receivables to go uncollected. After the downturn and during the recession (from 2010 to 2013), this stabilized with a 0.79 percent allowance percentage. In other words, the default risk is measurable even when spread across a diverse customer base.

The default risk can be segregated between secured accounts and unsecured accounts. Breaking down Grainger’s receivables performance during the downturn, one could expect to find a measurable difference between secured and unsecured accounts. Understanding this distinction would enable Grainger to more accurately account for its risk and earnings. It also likely would influence Grainger to increase the priority of its security rights, as doing so would increase its earnings.

Working capital is key to construction industry participants, and when the fiscal end of year comes along, reporting that working capital, along with the company’s assets and earnings, is key to demonstrating a company’s health and performance.

Security is available to everyone who touches the construction industry, and the “secured position” of an account has real measurable impact on corporate figures. Accountants, executives and financial managers should pay closer attention to the security position of their accounts, and leverage the same to increase earnings and performance metrics.

One Reply
  1. Contemptuously with the publication of this article here on CE’s eRisk Management, the Wall Street Journal published a related article in its CFO Journal. That article is here: “Embrace Digital or Put Your Company At Risk.”

    This is very important stuff from CFOs and construction financial professionals…and even owners, and other executives.

    Intangible assets and expenses are popping up on earning reports and balance sheets throughout every industry. Security rights is a low hanging fruit for the construction industry. They need to be in control of this data, because the by-product of controlling this is two-fold:

    1) They can actually use the security rights to improve and optimize the performance of their A/R; and

    2) They can take advantage of intangible assets (i.e. security rights) to improve their balance sheet.

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