Given an accrual tax return, in what scenarios would you recommend actually including bad debt expense?
How will you know that they have bad debts?
First, note that you will only see bad debts on a tax return completed on the accrual basis. So, with cash basis statements you may not notice them.
Instead, the reported revenue will be down, but you will not know if they earned less or did not get paid yet (receivables are up) or if they did the work but will not get paid (bad debts).
Multi-year operating cycles?
Additionally, in aglending and some other business types, some of your business owner/operators may have multi-year operating cycles, be expanding or contracting their operation, or just made a change that will take a few years to impact revenue (like replanting an orchard or a winery shifting to more drought resistant grapes in farming). So if revenue is down, it does not translate into “business is in trouble,” nor does it mean they have customers who did not pay if the return is cash basis.
Ask the right questions
Since there is no answer as to whether or not you should always add back or always leave the bad debt expense, I would look at the trend first. Is the amount of bad debts this year unusual in amount?
If it is significant, I would want to know more.
Is this one customer that got into trouble or is their entire customer base struggling? If that is the case, do they have the liquidity, borrowing capacity, and guarantor strength to withstand a continuing challenge?
If it was unexpected, have they made any changes to their internal credit decisions or process? Should they?
If you are the analyst, those are the questions to ask. If you are the analyst’s manager, you want the write-up to reflect that the analyst considered these questions, what conclusions they drew, and how those conclusions impacted their loan recommendation or decision. The detail in the write-up will help with decisions on the next loan, as well as showing a regulator that the judgment applied made sense.
Logistically, there are three choices in the numbers analysis.
- Add back the bad debts if they are unusual in amount you believe they are non recurring. Say why.
- Do not add back the bad debts but mention in your write-up that you discussed with the operator, what you found out, and what you expect to happen next. If the borrower still qualifies this will remind the analyst and let others who need to know (credit mgmt, next year’s credit analyst, loan review, regulators) that you saw it, considered it, and recommend it be monitored if need be.
- Same as #2 – but if this makes the loan decision more challenging, the analyst may need to consult with their manager to check their thinking and judgment. Perhaps the loan covenants need to be changed to monitor the situation more frequently.
Beyond number crunching
Do those ideas resonate with you?
In our training, we talk about this type of thinking (beyond rote number crunching) a lot. We train the basics and when something like this comes up in an analysis, it is the opportunity for the on-the-job trainers (managers) to help you develop your judgement.
Cash vs accrual, recognizing nonrecurring expenses, and spotting (and resolving) red flags are three of the many aspects of cashflow analysis of tax returns we cover at www.LendersOnlineTraining.com. Time for basic training or a refresher? Take a look!