Write-down of receivables in the balance sheet: how to orientate yourself

The bad debt provision in the balance sheet is an adjusting item that must be entered in the accounts to provide for the possible insolvencies of receivables not paid by the company's customers.

But the scheme established by the tax regulations does not provide a special space for recording these defaults. According to the logic of the accrual principle, in fact, the balance sheet indicates the possibility of realisation of a receivable that a customer must pay to the company.

So what are the procedures to be applied when writing down receivables in the balance sheet? What are the different types of receivables subject to impairment? What are the tax laws that deal with the regulation of the write-down of receivables?

In addition to an allowance for bad debts, why is it important to establish an allowance for bad debts?

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What is a receivable?

First of all, it is appropriate to establish the basics and understand what a receivable is before embarking on the understanding of its impairment.

From a legal and juridical point of view, a receivable is the relationship that is established between two parties, a creditor and a debtor, and which stipulates that a sum of money granted by the creditor to the debtor, must be returned according to the terms and timing agreed upon between the parties.

In accounting language, however, these are elements that can be found within the balance sheet, in the respective sections of current assets and intangible assets, more specifically at the level of financial assets.

Thus, it is important to bear in mind that this classification is based on a criterion of origin, i.e. the difference between a receivable of a financial nature and a receivable of a commercial nature.

Receivables are subsequently divided into receivables due within one year and receivables due beyond one year.

Receivables of a financial nature are receivables that are of a strategic nature, whereas receivables of a commercial nature are the result of ordinary operations.

Now that we have understood the basics, let us move on to the part that interests us most, namely the write-down of receivables.

The procedure to be followed for the year-end write-down of receivables

Section 8 of Article 2426 of the Civil Code states that:

" receivables shall be recognised at their estimated realisable value".

How, then, is the presumed value of a receivable to be recorded?

The answer lies in the creation of an allowance for doubtful accounts, since the latter is capable of recording both already manifest and reasonably foreseeable losses.

Calculation Methods

OIC No. 15 states that the impairment of receivables in the balance sheet must be accounted for by examining

• of individual receivables;
• of any other existing or anticipated facts.

Being, as the name indicates, valuations, they are not objective calculations but subjective estimates.

Therefore, as the OIC standard states, they must be based:

" on reasonable assumptions, using all available information, at the time of the valuation, about the situation of the debtors, based on past experience, the current general economic situation and sector, as well as events occurring after the end of the financial year that affect the values at the date of the financial statements".

To arrive at such a quantification, you have two accounting models at your disposal:

• the analytical method;
• the synthetic method.

The analytical method analyses the valuation of each individual claim. The synthetic method, on the other hand, is based on the identification of a lump-sum percentage that is calculated according to specially predefined coefficients.

The Analytical Method

The analytical method is based on two constants for the impairment of receivables in the balance sheet:

• the analysis of receivables one by one and the determination of the assumed losses for each bad debt scenario that has already occurred;
• the estimation to calculate further unforeseen losses. This factor is based on past experience that has already occurred and on other useful elements such as an assessment of the seniority of the receivables and an evaluation of the general economic, industry and risk conditions of the country in which the company operates.

The lump-sum method

The alternative to the analytical method is the lump-sum method. This system, which is always used to calculate the impairment of receivables in the balance sheet, is only used in certain special cases.

Receivables are valued according to the principle of estimation, which is assessed according to different variants:

• the seniority of past due receivables compared to those of previous years;
• the general economic conditions;
• the specific economic conditions of certain sectors or particular geographical areas.

This method of calculation, however, can only be used for the calculation of receivables:

• of small amounts;
• that behave in a regular manner, without presenting anomalies.

Moreover, it cannot be used systematically and continuously as the benchmarks change each time conditions change.

Rather, this method is considered a practical calculation system because the correspondence between the applied parameters and the actual conditions is constantly changing.

Regardless of the method, the ultimate aim is to show losses that have a reasonable chance of occurring.

But where should this information be included in the balance sheet? Let us look at it together.

Where is impairment of receivables to be recorded?

Article 246 C.C. No. 8 establishes the format of the E.C. balance sheet, therefore, the recording of receivables is not done according to the risk or loss value, but according to the possible realisation value.

On the liabilities side of the balance sheet, there is no section to indicate the adjustment of receivables.

In the income statement, on the other hand, in the section COSTS OF PRODUCTION no. 10 depreciation and amortisation, letter d) write-down of receivables included in current assets and cash and cash equivalents, any write-downs and losses of trade receivables may be recorded.

Thus, in accounting terms, the write-downs provided for may be entered in the income statement under cost 10 d) and thus have access to the provision for bad debts.

However, in order to remain faithful to the balance sheet format, when the accounts are to be reported, the allowance for doubtful accounts will have to be deducted from the accounts receivable.

The unused bad debt provision set aside at the end of an accounting year can be used to cover any losses incurred on receivables in subsequent years.

Why was the allowance for doubtful accounts established in the annual accounts?

The CEE balance sheet layout does not include the item of the allowance for doubtful debts.

In fact, up to now the CEE balance sheet layout does not provide for the existence, among the liability items, of a special provision for bad debts. Their recording in the accounts, therefore, must take place according to their presumed realisable value.

For this reason, the allowance for doubtful accounts has been included in the current assets item 'Accounts Receivable from customers C II 1) of the assets side of the balance sheet of the EEC format balance sheet'. And the creation of the accounting provision serves to account for the decrease in the value of the item entered under assets.

Categories of Receivables

Trade receivables

In accounting, following the receipt of revenue from the sale of goods or services (typical of a business activity), a trade receivable must be recorded as a balancing item in order to follow double-entry rules.

Trade accounts receivable also include all bills of exchange and accounts showing outstanding customer payments.

According to Article 2426 No. 8 of the Civil Code, the company must record receivables at their estimated realisable value in the annual balance sheet.

The allowance for doubtful accounts will be the accounting document where trade receivables, considered to be of doubtful collectability due to an already verified or strongly possible risk, will be grouped together.

In order to comply with the general principle of prudence laid down in company accounting, it will be necessary to take account of receivables recorded after the balance sheet date, which, however, affect prior figures.

Other Receivables

Apart from trade receivables, mention must be made of all other existing receivables that are not classified in this category:

• pledge;
• mortgage;
• surety;

For these receivables, the company must consider

• the enforcement of the guarantees themselves;
• the valuation of insured receivables, which is assessed according to the share of risk not covered by the insurance company.

A further subdivision

The accounting standard OIC No. 15, as we have seen, defines the general guidelines for determining the correct value of receivables to be recognised in the balance sheet. These guidelines can be used to try to identify various methods or processes for determining the correct provision for bad debts. We thought, therefore, to try to describe a possible process for the valuation of receivables, as a potentially usable model for trading companies.

Customer receivables can be categorised into three groups:

• receivables from customers in respect of companies for which bad debts have already arisen (bankruptcy, composition with creditors, etc.), irrespective of whether the receivables are past due or not;
• receivables from customers that are past due and not collected;
• receivables from customers that are not past due.

Receivables in the first category must be analysed analytically, as the company has accounting data to determine, receivable by receivable, the impairment value.

Receivables in the second category may be calculated on the basis of the estimation process ' based on experience and other factors'. For their calculation, either the analytical or the lump-sum method may be used. The choice between the two methods will depend on the situation:

• calculation of individual claims, if the information system allows an adequate assessment of the impairment for each individual case;
• calculation of homogeneous categories of claims compared with the time elapsed since the expiry of the agreed deferral.

Receivables in the third category are not yet due and therefore do not have to be written down, especially if they are receivables from customers whose companies are not in a situation of insolvency. However, even minimal impairment is possible if, as a result of past experience, a minimum loss percentage can be calculated.

If the bad debt is part of an already manifested bad debt situation, then a separate analysis will be required.

What are the factors contributing to the write-down?

The OIC standard states that any other useful factors may be used in calculating the impairment of receivables.

But what are these other useful elements that contribute to the final result?

Usually, every company has information systems that are capable of producing a record of overdue receivables, divided into equivalent categories according to the time elapsed between maturity and deferral. Here is an illustration of the situation:

Next, a write-down percentage must be chosen to be adopted to the book balances of the equivalent individual categories.

Once the individual write-downs have been determined, they must be added together. The result obtained will correspond to the ceiling of the allowance for loan losses, which in the annual balance sheet, will represent the presumed realisable value, being the direct reduction of the nominal value of the receivables.

The calculation becomes more complex when establishing the impairment percentages to be applied to the account balances for the different equivalent categories.

These percentages must follow the following general rule:

The more the time elapsed since the due date increases, the more the probability of collection of the receivable decreases and therefore the percentage of write-down to be applied will have to increase.

The percentage increase will also increase according to the historical average insolvency figure in the company's books.

In this image you will find a possible example of depreciation rates, calculated on the basis of previous experience.

Please note that the calculation must also analyse those credits that:

• Are covered by guarantees such as pledge, mortgage and surety
• Are valued on the basis of enforcement
• Are insured for the amount not covered by the association

Legislation on the Impairment of Receivables

All the tax information concerning the write-down of balance sheet receivables is summarised in Article 106 of the TUIR (Presidential Decree No. 917/86).

In this article, write-downs of balance sheet receivables can be deducted for IRES purposes according to a flat-rate criterion:

• 0.5 per cent of the nominal or acquisition value of the receivables recorded in the balance sheet in the case of maximum deductibility or until the total amount of write-downs and provisions has reached 5 per cent of the nominal value of the receivables recorded in the balance sheet.
• In the event that the provisions exceed the limit of 5% of the loans recorded in the balance sheet, the excess cannot be deducted for tax purposes, thus producing an increase in the single tax return.

Continuing to analyse this tax law, we can divide loan loss provisions into two categories:

• Allowance for bad debts that can be deducted for tax purposes, based on what we have just said about the TUIR article;
• Provision for bad debts not deducted for tax purposes, which takes into account the difference between statutory provisions and deductible provisions, again based on the aforementioned article.

Again analysing the TUIR article, when hedging for future credit losses, the non-deducted bad debt provision causes a negative change in the annual tax return. This tax manoeuvre is performed in order not to totally lose the portion of the provision not deducted at the time of allocation.

What happens when the collection of debts becomes doubtful?

Debts should not be presented in the company's balance sheet according to their nominal value, but according to what the company believes it can actually collect from its debtors. The principle is to be prudent so as not to overestimate the company's capital.

This implies that the value of receivables must be adjusted and adjusted in the accounts. Three hypotheses are to be considered

• the write-off of bad debts;
• the provision for bad debts;
• the provision for bad debts.

The estimated realisable value of receivables: what is it?

As we explained earlier, receivables should not be entered in the balance sheet at their nominal value.

What does this mean in concrete terms?

Receivables are presented in the balance sheet, according to the provisions of Article 2426, No. 8 of the Civil Code, at ' estimated realisable value'. Subsequently, the nominal value of receivables must be adjusted by taking into account expected losses, discounts, other causes, billing adjustments, etc.

In addition, Article 15 of the OIC states that the nominal value of receivables must be adjusted ' by means of an allowance for doubtful accounts to take account of the possibility that the debtor may not fulfil its contractual commitments in full. The allowance for doubtful debts adjusts receivables recognised as assets'.

What is bad debt provision?

These are all those receivables that the company is sure it can never collect. In fact, in Italian, when the verb ' stralciare' is used, it means 'the act of removing or removing an item from a collection'.

Thus, in accounting, the purpose of the write-off process is to implement all the procedures necessary to extinguish a debt.

Generally, this decision is made when the enterprise realises and is certain that the debtor has become insolvent (judicial liquidation procedures, declaration of bankruptcy, etc.).

The enterprise, for instance, makes a write-off when it sees that the claim has been overdue for a long time and that all legal procedures have been undertaken against the debtor, but to no avail. In this case, the company recognises a credit loss.

What is a bad debt provision?

Not all receivables present a risk of default. For this category of receivables, there is no risk of default when they fall due.

However, in order to keep impeccable accounts, it is advisable to provide for the possibility of a general risk of default.

For this reason, a provision for bad debts should be established for the portion of receivables that has not been collected and for which insolvency had not been calculated.

For example, you know that every year 2% of your customers will not make payment for the amounts owed.

The accrual principle requires that any losses be recorded in the current year, even if the defaults occur in the following year(s).

At the double-entry level, we will have the following accounting entries

• an expense in the debit side of the bad debt account;
• a negative financial variation in the debit side of the bad debt provision account.

To determine the value to be written in the above items, the calculation is as follows:

1. we add up the receivables for which there is no highly probable risk of default. In our case, we arrived at an amount of €50,000;
2. the average insolvency probability of our company is calculated. As we said, this corresponds to 2%. So we make 2% of 50,000 euros;
3. we set up a credit risk provision corresponding to the calculated amount. Once the adjustment entries are made, the insolvencies amount to, say, 4,000 euros. Therefore, it will be necessary to have a bad debt provision of EUR 4,000 so that the bad debt provision assumes the same value. However, if the allowance for bad debts already had a ceiling of €2,000, and the calculated bad debts are €4,000, then the allowance for bad debts, and consequently the allowance for bad debts, must correspond to €2,000. Thus, once the adjustment entries have been made, the value of the provision will rise to €4,000.

How should the provision for bad debts and loan loss reserves be used?

In order to comply with the rules of the accrual principle, the use of these two provisions must come into play when there are accounts receivable booked in years prior to the current year.

In the event of a loss occurring in the current year, this insolvency must be accounted for in the current year.

In the event of an insolvency scenario, there are two possible cases:

1. receivable belonging to the current year: the bad debt is written off and a loss on the receivable is recognised.
2. receivable belonging to previous years: the uncollectable receivable is recorded against the provision previously set aside. In this case, three situations are possible
   1. without the provision for liabilities, the receivable must be entered under "non-existent liabilities";
   2. if the fund exists and is able to cover the loss in its entirety, the receivable must be entered as a decrease in the previously set aside fund;
   3. if the provision exists and is able to cover the loss in its entirety, the provision in question will cover the receivable up to its maximum limit and the remainder will be shown as a non-existent liability.

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The guarantee fund to offset uncertainty of tax treatment

The guarantee fund is one of the solutions that the company can resort to in order to obtain credit insurance to balance the uncertainty arising from tax treatment. It is a kind of protection that every company should think about doing, because credits are always accompanied by great uncertainty about their repayment.

This type of initiative helps companies offset losses from uncollected receivables, but not only that: it is a perfect aid for identifying and anticipating foreseeable losses, even before they occur.

They thus ensure that the uncertainty of tax treatment is completely eliminated. Given their effectiveness, the costs of such insurance remain acceptable.

At the end of this long overview, do you still have questions on the subject? Given its complexity, let us know your opinion on it in the feedback section in the comments.