How Bad-Debt Policies Affect Ad Revenue

I once had a boss who manipulated year-end net income by forbidding any discretionary spending until he had a good sense of whether the year’s revenue would be as good as, or better than, budget. Then, sometime after September, when he was comfortable we were going to make our number (and he’d be getting his bonus), we’d stock up on copy paper, pens, coffee, paper towels, and other essential office supplies. Someone at corporate finally got wise to the unusual spending pattern and a change in management followed.

Thomas Foster, director of audit at Media General, says that the decision between treating an unpaid advertising account as past due or bad debt will also impact reported year-end income … and employee bonuses. However, as was the case with my former boss, someone, most likely an auditor, will notice a pattern of bad estimates. So, it’s best to be prepared for the questions before external auditors make their annual visit to your office.

The Bottom Line Impact Of Bad Debt

Auditors tend to focus on accounts that require judgement and are subject to management overrides. Unpaid advertiser accounts certainly fit this description. Foster explains: “After all, a $1,000 decrease in the allowance will reduce bad debt expense and increase net income before taxes by the same amount. So there may be no easier way to manipulate net income in order to improve a bottom line. That could boost cash bonuses paid to management.”

While part of the external auditor’s job is to ensure companies don’t engage in fraudulent financial reporting, it’s the job of internal auditors like Foster to ensure their companies understand and follow the accounting and tax rules that govern management practices.

As he pointed out in a “Last Word” item appearing in the January/February 2016 edition of MFM’s The Financial Manager magazine (TFM), “External auditors won’t raise a red flag over reserves for doubtful accounts if estimates are carefully calculated.”

Categorizing Doubtful Accounts

Foster says companies usually choose between two accepted methods for estimating the portion of their past due accounts that should be treated as bad debt:

• Calculate the allowance subjectively based on their knowledge of each customer’s ability to pay, or
• Calculate an allowance that uses a formula based on the past experience of actual bad debt expense.

“If the bulk of the accounts receivable stems from a small number of customers,” Foster says, “it’s probably worth spending the time to calculate the allowance subjectively by performing a detailed customer-by-customer accounts receivable analysis.”

In this scenario, the company analyzes every customer account to determine its current receivable balance and historical write-off percentage. From there, it assigns a rating to each customer indicating the risk that they might have to write off a portion of the customer’s balance.

Foster says: “By grouping customers into categories (such as low, medium and high), a company can assign a bad debt allowance percentage to each which is multiplied by the category balance to determine the amount of the reserve.”

If the station or company has a large number of receivable accounts, a more formula-driven approach may be better. Examples include determining either a percentage of write-offs or percentage of accounts receivable by aging category.

“To take the percentage of write-offs method, management could determine actual write-offs each month/year over the past several years as a percentage of another related business measure, such as sales,” says Foster. “In theory, the amount you wrote off in the past represents a good indicator of future write-offs.”

Foster prefers using aging categories (with past-due buckets in increments of 30 days) “because the longer an account is past due, the less likely you are to collect that money,” meaning management should reserve a larger percentage of sales for older debts.

Enter The External Auditors

External auditors use additional techniques to evaluate the adequacy of a company’s bad debt allowance. They include:

• Comparing bad debt expense to write-offs — While estimated bad debt expense won’t perfectly match actual write-offs in a given year, auditors consider it reasonable to expect a ratio of close to 1.0 over an extended period. Foster explains: “Ratios calculated for multiple years that are substantially lower than 1.0 might suggest the entity tends to underestimate the impact of their collection problems.” Conversely, multiple-year ratios significantly exceeding 1.0 may signal that the entity is accumulating an excessive allowance.
• Contrasting beginning allowance for doubtful accounts with write-offs — This approach can be used to indicate how well the allowance has accommodated subsequent write-offs. “Lower ratios suggest the beginning-of-year allowance may not have been large enough to absorb impending write-offs,” Foster says, “while inordinately high ratios might indicate the entity has amassed excessive allowances.”

In Foster’s experience, “external auditors might examine at least three years’ worth of data in order to ensure the current-year data is consistent with the trend.”

Industry Benchmarks

External auditors also like to compare an individual company’s bad debt allowance with industry peers who have a similar customer base.

MFM has continued to focus on ways that it can be a resource for our member companies in this regard. For example, our DSO (Day Sales Outstanding) benchmarking reports can provide companies with information to determine how a station’s or groups’ past due account ratios compare with other groups.

To help companies ensure they are making informed credit decisions, another way to reduce bad debt, MFM’s BCCA subsidiary has launched “Media Whys,” the industry’s first continually updated industry-specific credit reports. These reports include a credit score based on industry-specific aging and trade data from Experian or D+B.

The Media Whys “credit logic score” is a 0-100 score indicating risk of severely delinquent payment. Reports also include a payment trends graph which illustrates whether the company is improving, declining, or stable. In addition, BCCA members can add online Media Whys credit decisioning tools to automate routine credit decisions and/or a company-specific aging analysis.

A copy of the January/February edition of TFM containing Thomas Foster’s article will be available on MFM’s website for several more weeks. If you are interested in additional information about media industry accounting practices, you may also want to look for MFM’s Understanding Broadcast & Cable Finance – A Primer for Nonfinancial Managers handbook, which is available at the NAB Store among other locations. 

As Media General’s Thomas Foster observes, “If management has the right tools, the right data and the right estimation method, then the audit analysis performed by their external auditors should prove the allowance properly reflects net realizable value of the accounts receivable balance.”

This approach will make it much easier for your management team to feel comfortable in those meetings with external auditors. In addition, it will give your ad sales managers greater confidence in those “final” year-end numbers.

Mary M. Collins is president and CEO of the Media Financial Management Association and its BCCA subsidiary. She can be reached at [email protected]. Her column appears in TVNewsCheck every other week. You can read her earlier columns here.