Budgeting and management of bad and doubtful debts, By Bolutife Oluwadele

In running an organisation, nothing should be left to chances. Adequate planning is critical to any success, even in difficult areas. As a result of this, the incidence of doubtful and bad debts should be adequately managed to reduce defaults to the barest minimum, as that is a sure safety value to maintain in business profitability and liquidity.

Introduction

In this article, we will painstakingly look at the three elements surrounding the issue of doubtful and bad debt. However, we would also require a working understanding of the terms’ doubtful’ and ‘bad’ debts.

In doing this, we ask why debts that have been analysed before being granted become ‘doubtful’ or completely bad? Is it not an unnecessary loophole to even make provisions for doubtful debts, knowing that staff can exploit this, even in connivance with customers?

Many more questions could be asked. In organisations, some are well informed about business dynamics, and others are not so informed. Hence questions like these arise. However, before we attempt to answer the questions that remain the crux of this article, we shall attempt to define the terms involved.

Doubtful Debt

This is the likelihood that a customer or debtor will default in settling his debts when due. Sometimes the signal for this is received through experience, in terms of trend analysis, and therefore provisions are usually made in the event of such occurring. A good debtor may, at any particular time, give in the signal that he may not pay as at when due.

Significantly though, it is not certain that he will not pay at all, so for him, all hope is not lost, but one is put on the red alert all the same.

Bad Debt

This is the certainty that the debt is no longer recoverable. When it is inevitable that a debtor will not settle his accounts, the debt is treated as ‘bad,’ and the amount lost is treated as an expense.

When and How Do Debts Become Doubtful Or Bad?

For the banking industry, this has been simplified by the Prudential Guidelines issued by the Central Bank of Nigeria.

The Guideline stipulates that debt should be categorised into performing and non-performing. It is also stipulated that an age analysis of each debt should be done so that they can easily be categorised as doubtful or bad debts. A debt not serviced for a period of 180 to 360 days is already becoming doubtful. Furthermore, if it exceeds 360 days, it can be categorised as a bad debt.

Besides, a general provision of 1 per cent is made for all debts, performing or non-performing, in order to guide against overstating the profits earned by a firm.

This standard is not applicable in a legal and statutory form in other industries. Nonetheless, each company formulates policies considering the peculiarities of their industries, to determine the point at which a debt becomes doubtful or bad.

As such, when all recovery efforts are becoming doubtful, then debts can be categorised as doubtful. This will usually occur when:

Promises to pay are not honoured;
There is a continuous plea for extension of grace periods or rescheduling;
There is a likelihood of insolvency on the part of the debtor;
The debtor is going through a lengthened liquidity crisis;
The debtor becomes simply evasive.

On the other hand, a debt is considered bad when:

There is a prolonged period of unsettlement;
The debtor is dead;
The debtor is insolvent;
There is a complete collapse of the debtor’s business.

At this point, the debt is written off as an expense in the profit and loss accounts

Supervision, Budgeting, and Management

Managing these three issues will significantly determine how the earlier questions will be answered.

Supervision

The need for adequate supervision of credit control cannot be over-emphasised. The reason is that without adequate supervision, a loophole would be created that can be manipulated to the disadvantage of the firm.

The supervision of debt should employ the following, amongst other techniques:

(a.) Monitoring

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There should be periodic and constant monitoring of the credit-control section to determine their recovery efforts’ adequacy, sincerity, and efficiency. Of course, this should be conducted by officers not directly involved in recovering debts. Those monitoring could employ a supervised checking principle.

(b.) Setting Credit Limit

A credit limit should be set for individual customers in order to safeguard the incidence of doubtful and bad debts. In setting the limit, consideration should be given to the customer’s financial standing and other factors, as revealed in the credit analysis.

(c.) Security

Adequate security should be taken to mitigate the losses incurred in the event of debts going bad. Such security could include guarantors, bonds, assets collaterals, and convertible legal instruments.

(d.) Controlling;

There should be a lot of inbuilt control mechanisms that ensure the following:

Separation of authority to approve, recover and write off;
Non-granting of further credit to a defaulting customer;
Any customer does not exceed the credit limit
Adequate checking of the credit-control section

Budgeting

It is imperative that adequate planning is in place in every sphere of an organisation’s operations. Since the issue of doubtful and bad debts impairs an organisation’s liquidity significantly, thorough planning should be made for it, i.e., it must be provided for in the budget.

In budgeting for doubtful and bad debts, the following will be taken into consideration:

The past trends, in terms of volume of credit sales, remittances period, and defaulting trends;
The growth in sales budgeting, as well as in market share;
The general trend in the economy;
The standard in the industry, i.e., the industry average;
The effects of the external environment such as government policies, globalisation, and competition;
The overall corporate objective.

The summation of this consideration will enable the firm to determine

The quantum of credit sales it can allow for a given period;
The percentage of provision to be made based on (1) above;
The cost of recovery in a given period
The margin of safety.

Management

Since the imperativeness of credit transactions as a tool for modern businesses cannot be wished away, it behooves each organisation to manage its credit to mitigate against huge losses effectively.

The following tools, amongst others, can be employed to manage doubtful and bad debts to reduce their volume.

Information

There should be sufficient and up-to-date information about each customer to determine the amount of credits that can be granted. Sometimes the cost of this information may be exorbitant, but if its benefits are higher, it is worth it.

This information should not be limited to a particular source only but as much as possible to various sources.

2. Reconciliation

The information provided by the accounts department should be constantly reconciled with that of credit control, the sales department, and all those involved in the cycle.

3. Analysis

There should be a monthly analysis of debtors. The age analysis of each debtor should be made, and the efforts at recovery clearly indicated.

4. Rotation of Staffs

Sometimes to guide against connivance, there may be a need to rotate the credit-control staff attached to each customer. Although some organisations believe that a particular staff managing a specific customer is better, this may be counter-productive in some instances, especially if a staff manages a sizable number of customers.

5. Efficient Recovery Strategy

The organisation must put an efficient recovery strategy that is not too expensive to outweigh its benefits.

Conclusion

In running an organisation, nothing should be left to chances. Adequate planning is critical to any success, even in difficult areas. As a result of this, the incidence of doubtful and bad debts should be adequately managed to reduce defaults to the barest minimum, as that is a sure safety value to maintain in business profitability and liquidity.

Bolutife Oluwadele, a chartered accountant and a public policy and administration scholar, writes from Canada. He is the author of Thoughts of A Village Boy and can be reached through: bolutife.oluwadele@gmail.com