Should You Count Bad Debt Expense Against Cash Flow?

Erik asks:

Given an accrual tax return, in what scenarios would you recommend actually including bad debt expense?

Linda says:

Identifying Bad Debts:?Firstly, bad debts are only visible on accrual basis tax returns. For cash basis statements, bad debts aren't explicitly listed. Instead, you may notice reduced reported revenue. This reduction could be due to lower earnings, unpaid receivables, or completed work for which payment will not be received (bad debts).

Consider Multi-Year Operating Cycles:?In industries like agricultural lending, some business operations have multi-year cycles. This can include periods of expansion, contraction, or significant changes such as replanting orchards or transitioning to drought-resistant crops. A decline in revenue in these cases doesn't necessarily indicate financial trouble or unpaid customer accounts, especially on a cash basis return.

Ask the Right Questions:?Deciding whether to include bad debt expense isn't always straightforward. It's crucial to analyze trends first. If the amount of bad debts this year is unusual, it warrants further investigation. Key questions include:

• Is this issue isolated to one customer or widespread across the customer base?
• Does the business have sufficient liquidity, borrowing capacity, and guarantor strength to handle ongoing challenges?
• Have any changes been made to internal credit policies or processes?

If you are an analyst, these are the questions you should ask. As a manager, ensure the analyst's write-up reflects consideration of these questions, the conclusions drawn, and their impact on loan recommendations or decisions. Detailed write-ups support future loan decisions and demonstrate sound judgment to regulators.

Logistical Choices in Analysis:

There are three main approaches to handling bad debts in your analysis:

1. Add Back Unusual Bad Debts:?If the bad debts are unusual and considered non-recurring, add them back. Clearly explain why.
2. Do Not Add Back but Document:?If not adding back the bad debts, mention your discussions with the operator, your findings, and future expectations in your write-up. This documentation helps ensure all relevant parties (credit management, future analysts, loan reviewers, regulators) are aware of the issue and its context.
3. Consult and Monitor:?Similar to the second option, but if the loan decision becomes more complex, the analyst should consult with their manager. Adjust loan covenants if necessary to monitor the situation more frequently.

Beyond Number Crunching:

Do these approaches resonate with you? In our training, we emphasize critical thinking beyond basic number crunching. Learning the fundamentals is essential, but real-world scenarios offer opportunities for managers to help develop analytical judgment.

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Who is Linda?

Linda Keith, CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Returns and Financial Statement Analysis. She is in the trenches with lenders, analysts, and underwriters helping them say "yes" to good loans. Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending, and director finance topics.

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