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The bad debts provision in the indirect method cash flows statement.

As required by FASB Statement No. 95 (SFAS No. 95, Statement of Cash Flows), a company that provides a set of financial statements that reports both financial position and results of operations should also provide a cash flows statement for each period for which results of operations are provided. The cash flows statement should explain the change during the period in cash and cash equivalents, and should classify cash receipts and cash payments as resulting from investing, financing, or operating activities. Perhaps the most important figure in the cash flows statement is cash flows from operations.

There are two methods of deriving cash flows from operations - the direct method and the indirect method. Under the direct method, cash flows from operations are the difference between cash collections and operating cash payments. Under the indirect method, cash flows from operations are derived by adjusting net income for noncash revenues and expenses and nonoperating gains and losses.

Although SFAS No. 95 permits the indirect method, it recommends the direct method. But companies that use the direct method must also provide a supplemental disclosure reconciling net income and cash flow from operations. Thus, all companies must use the indirect method - either to prepare the cash flows statement or the supplemental reconciliation disclosure. Most companies use the indirect method.

Revenue Adjustment or Noncash Expense?

The treatment of the bad debts provision in the reconciliation of net income and cash flows from operations under the indirect method is particularly troublesome and worthy of examination. Reporting the bad debts provision as a noncash expense and adding it back to net income to derive cash flows from operations under the indirect method is illustrated in the fast comprehensive example in Appendix C of SFAS No. 95. The addback is complex and potentially confusing, largely because the related adjustment for the change in accounts receivable does not equal the change in accounts receivable in the comparative balance sheet.

A much less comprehensive example, demonstrates that the reconciliation can be more straightforward and easier to explain when the bad debts provision is viewed as a revenue adjustment like sales returns and excluded. Rather, the reconciliation should adjust net income for the change in accounts receivable - net or, less preferably, the changes in accounts receivable - gross and the allowance for uncollectible accounts. This is another reason why it is more logical to view the bad debts provision as a revenue deduction rather than an operating expense for both cash flow statement and income statement purposes.
TABLE 1
UNDERLYING INFORMATION

Balance Sheet Data                      12-31-x2       12-31-x1

Accounts receivable                     $ 50,000       $ 30,000
Allowance for uncollectible accounts     (10,000)        (5,000)
Inventories                               85,000         90,000
Accounts payable                          50,000         40,000
Accrued expenses payable                  17,000         15,000

Income Statement Data                                     19x2

Sales revenues                                          $370,000
Gain on sale of plant and equipment                       15,000
Cost of goods sold                                       165,000
Depreciation expense                                      25,000
Bad debt expense                                          20,000
Other expenses                                           145,000


Illustrative Example

There are at least three ways of factoring the bad debts provision into the reconciliation of net income and cash flows from operations, as illustrated in Table 2.

Underlying data are found in Table 1, and include balance sheet and income statement items.

Alternative A. The simplest reconciliation of net income and cash flow from operations results from adjusting net income for the change in accounts receivable - net, that is, the change in accounts receivable less allowance for uncollectible accounts (see Alternative A column of Table 2). Under this approach, the reconciliation does not include a separate line item for the bad debts provision. Implicitly, the bad debts provision is viewed as a revenue deduction like sales discounts, returns, and allowances, rather than as a noncash expense; the adjustment equals the difference between the cash collections from customers and revenues net of discounts, returns, allowances, and bad debts.

The major advantage of Alternative A is simplicity. This type of reconciliation involves the fewest line items. It conserves space and, moreover, should be easier to understand than Alternatives B or C. Many companies use this type of reconciliation in their cash flows statements.

Alternative B. A slightly more detailed reconciliation of net income and cash flows from operations involves adjusting net income for changes in both accounts receivable - gross and allowance for uncollectible accounts (see Alternative B column of Table 2). The additional detail of Alternative B results from having two line item adjustments rather than one, as in Alternative A. Like Alternative A, the bad debts provision is viewed implicitly as a revenue deduction rather than a noncash expense, and the reconciliation does not include a separate line item for the bad debts provision. This type of reconciliation is occasionally found in published cash flows statements.

Alternative C. A much more complex and potentially confusing reconciliation of net income and cash flows from operations results when net income is adjusted for the bad debts provision and the change in accounts receivable (see Alternative C column of Table 2) [TABULAR DATA FOR TABLE 2 OMITTED].

Alternative C is illustrated in the first comprehensive example in Appendix C of SFAS No. 95. Like Alternatives A and B, Alternative C may be rationalized as a means of adjusting net income for the $20,000 bad debts provision, an operating expense that does not involve a cash outflow. But to correctly derive the $42,000 cash flows from operations, net income is adjusted for a $35,000 increase in accounts receivable. As such, the $35,000 adjustment does not equal the change in accounts receivable reported in the comparative balance sheet, hence it is potentially confusing to financial statement users.

SFAS No. 95 does not explain the nature of this $35,000 adjustment. Others describe it as either a) the $15,000 increase in accounts receivable - net before the $20,000 bad debts provision or, equivalently, as b) the $20,000 increase in accounts receivable - gross before the $15,000 write-off, but the meaning of such descriptions is not apparent. In fact, the $35,000 adjustment represents the difference between customer billings (net of sales discounts, returns, and allowances) and customer collections. It would be more understandable were it labeled excess of billings over collections rather than increase in accounts receivable, but this is neither considered in SFAS No. 95 nor illustrated in its example. Of course, the write-offs decrease the receivables asset and allowance contra asset by the same amount, hence have no effect on owners' equity or cash flows, and should not be included in the reconciliation.

Many companies use this type of reconciliation in their published cash flows statements. Few companies disclose that the change in receivables is before the bad debt provision.

Implications for Cash Flows Statement

Under SFAS No. 95, the change in operating receivables must be included as an adjusting item in the reconciliation of net income and cash flows from operations. Consistent with this requirement, the reconciliation is more straightforward and easier to explain when the bad debts provision is viewed as a revenue deduction not requiring addback, rather than as a noncash expense requiring addback to net income. Accordingly, the reconciliation should include an adjustment for the change in accounts receivable - net (Alternative A) or, less preferably, the changes in accounts receivable - gross and allowance for uncollectible accounts (Alternative B). It should exclude an adjustment for the bad debts provision (Alternative C), because the resulting adjustment for the change in accounts receivable - net would not equal the change reflected in the comparative balance sheet and hence is potentially confusing.

Alternatively, the bad debts provision could be viewed as a noncash expense and included as an addback adjustment in the reconciliation. But to make the reconciliation understandable, a negative (positive) adjustment for an increase (decrease) in accounts receivable before the bad debt provision should be more fully described as excess of customer billings over customer collections (or excess of customer collections over customer billings). Similarly, the decrease (increase) in inventories and increase (decrease) in operating payables should be combined as a single positive (negative) adjustment and more fully described as excess of operating expenses over operating payments (or excess of operating payments over operating expenses). Under the existing requirements of SFAS No. 95, however, where the adjustment must be described as the change in operating receivables, including the bad debts provision as an addback adjustment in the reconciliation is potentially confusing and not recommended.

Hugo Nurnberg, PhD, CPA, is a professor in the Department of Accountancy, Baruch College, City University of New York.
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Title Annotation:Accounting
Author:Nurnberg, Hugo
Publication:The CPA Journal
Date:Nov 1, 1996
Words:1420
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