The allowance for doubtful accounts related to student receivables is often the least precise measurement on a school’s balance sheet. Few items on a financial statement can have a greater influence on profitability. As an estimate of an institution’s expectation of what it will not collect from students’ accounts receivable, this can be a difficult figure to determine — you can never perfectly predict it. There is also no specifically mandated method to assess allowances, only the requirement that it must be reported on statements.
Reviewing accounts receivables and refining the estimate of the allowance for doubtful accounts, however, will unveil the picture of an institution’s true performance. Developing a methodology supported by data reduces unexpected fluctuations to a school’s profitability year-to-year that can negatively impact the composite score. Another benefit could be to reduce the number of questions from a potential buyer during diligence.
Considerations
- The student’s enrollment status is the most important factor when determining an allowance for doubtful accounts. Actively enrolled students are most likely to pay as they have a variety of resources available to them to continue to pay for their studies. Graduated students are reasonably likely to pay because they completed the program and likely feel they benefitted from the school. Students who dropped out of school are unlikely to pay. These students often believe the school didn’t deliver on expectations, so they aren’t obligated to pay.
- Another factor to consider is the timing of when payments are expected to be received to resolve the account. The sooner payment is expected, the more likely it is to occur. A lump payment prior to the end of the current term to resolve a balance from either the student or another resource is much more likely to be made than a stream of monthly payments from the student for years after they graduate.
Methods
The allowance for doubtful accounts is a management estimate attempting to predict future activity that includes a lot of variables and unknowns. The following are hardly the only ways institutions calculate their allowances, but they are a good overview of different methods.
- The most conservative method to account for allowances for graduate or withdrawn students is not to record one. Some institutions immediately write off students once they drop out of school. It’s true that once a student is no longer enrolled, the ability to collect from them decreases significantly — students in this position may feel they didn’t receive the end result they were promised by an institution. It is worth noting that the IRS requires a debt to be proven worthless before a company can take the bad debt deduction. It is reasonable that a small percentage of receivables will end up being collected. However, under audit, the IRS could question deductions taken for bad debt if too much of it is later being collected.
- Some institutions divide students into buckets by their enrollment status (typically active, graduate or withdrawn) and then apply a percentage for the allowance for each bucket. In these instances, active students have the smallest percentage for their allowance, followed by graduates and then withdrawn.
- Another method we see is to divide students into buckets based on the date of their last payment to the institution. Similar to the enrollment status method, the longer the period of time that has elapsed since the students’ last payment, the higher the percentage that is used for their allowance.
Some institutions incorporate a combination of these methods. There is no “right” way to determine the allowance, but it is important for schools to review and evaluate the characteristics of their student receivables and attempt to determine the factors that best identify which ones will or will not be collected.
Issues
Common issues that we see related to the allowance for doubtful accounts are as follow:
- Institutions are not regularly reviewing the percentages they use to account for allowances. Using the previous example, for instance, if we say the institution expects to collect 90% from students who are inactive from zero to 90 days, what happens when time bears out that the school is actually only collecting about 60% from these students? If the percentages go untouched in the allowances, institutions may begin underreporting expenses — sometimes by a significant amount — and the impact builds and is felt on their financial statements in future periods. In addition, auditing standards require a retrospective analysis of key estimates. Thus, management should be evaluating the actual collection history versus their estimates to be determine the reasonableness of the estimate.
- Some institutions will have bucket of students with a very large percentage being included in the allowance, even 100% at times. However, as mentioned above, tax regulations do not permit schools to recognize expenses utilizing the allowance method. The tax deduction doesn’t occur until the students’ balances are written-off. This means that receivables with 100% allowance have the bad debt expense fully recognized for book purposes with nothing recognized for tax purposes, clearly a less than ideal situation. In addition, schools might not maintain a schedule to track the students deemed to worthless during their fiscal year. Student balances that are written off should be compiled to support the bad debt deduction taken on the school’s tax return.
- Given that the allowance for doubtful accounts is often the balance on an institution’s balance sheet that is most susceptible to management estimate, it is nearly always a high priority item for a potential buyer performing diligence procedures. When the buyer is unable to articulate how the allowance is calculated and why, or the potential buyer determines the allowance is much lower than it should be, this can set a bad tone for the diligence or create a significant decrease in the offer price. If the buyer feels the seller could be aggressively underreporting their bad debt expense, it can cause them to look more closely for other areas where things might not be what they seem. A well-articulated and properly calculated allowance goes a long way in creating comfort for the buyer.
Best practices
Accounting for allowances on doubtful accounts is complicated — dealing with figures related to something that doesn’t exist may feel a little backward — but it doesn’t have to be so difficult. All it takes is consistency and attention.
Institutions must work out a method that gives them a dependably accurate picture of what they are not receiving. Utilizing percentages tends to work best, but only if they are updated at regular intervals over time by closely monitoring the amounts received and not received from inactive students.
For assistance in determining the best way to manage allowances at your institution or in conducting due diligence before a major transaction, the experts at McClintock & Associates are always on-hand for a consultation. Feel free to contact us for assistance.
