Page 55 - Finance for Non-Financial Managers

Siciliano03.qxd 2/8/2003 6:36 AM Page 36
Finance for Non-Financial Managers
36
This is one of the key cash flow planning issues that companies
face in managing their resources effectively. If Wonder Widget’s
customers don’t pay promptly, the company will have less
money to pay its suppliers, to order goods to replace those it
has sold, and to pay its employees.
A typical balance sheet may show other amounts due the
company than accounts receivable. They might include loans to
employees or officers, tax refunds from the government, and
other amounts due that are not strictly trade accounts with cus-
tomers. In all cases, by classifying them as current assets, man-
agement is expressing the expectation that these amounts will
be collected within a year.

Allowance for Bad Debts
Closely related to accounts receivable, but not always shown
separately on the balance sheet, is an account called
“Allowance for bad debts” or some similar title. This is a
reserve, an estimated amount the company provides for the
possibility that some customer balances will not be paid at all
and will have to be written off. Any company that sells on credit
has these kinds of issues to deal with—granting credit and man-
aging customer relationships so that collection losses are as
small as possible, consistent with good business practice.
Because companies cannot tell at first who will pay and who
will not, they often provide a reserve for such losses at the time
sales are made, typically calculated as a percentage of all sales
made in a given period. Such reserves will then absorb the cost
of bad debt losses that may be recognized in future periods.
In order to accomplish that, companies build reserves by
creating a write-off to expense. They then charge uncollectible
amounts off against the reserve whenever they decide they
will not likely collect the full amount due. At any point in time,
the allowance for bad debts is effectively a valuation adjust-
ment account that reduces the total amount of customer
accounts receivable on the books to the net amount expected
to be collected.