Bad debt provision is governed by FRS 26 which implements IAS 39, Recognition and Measurement. For those adopting international standards IFRS 9 would apply. Small businesses may apply FRSSE. In regards bad debt provision the standards remain consistent and therefore makes it easier for us to deal with. So what does FRS 26 have to say, and how specifically does it impact alternative lenders?
Requirements
Under accounting standards you are required to recognised interest and fees as they contractually fall due. Some lenders have attempted to only recognise interest and fees which are receipted. This would be incorrect and the lender is advised to revisit its accounting policy and discuss this with their external Chartered Accountants.
Assuming that lenders have recognised interest and fees correctly the lender is required at the balance sheet date to assess its loan book for impairment. In regards to the loan book this is not only the original principal lent, but also the accrued interest and charges that remain unpaid at the balance sheet date.
For ease, lenders can take a general approach and make general estimates of impairment against the debtor book.
Example 1.
For instance a lender may have £1m of principal, interest and fees owed to it at the balance sheet date. Historically they have experienced that at any time 10% of their loan book will go bad. So the lender ensures that the bad debt provision in the balance sheet is adjusted to £100k, with the other side going to the P&L.
The above example of a general provision is easy to calculate but not very tax efficient since the charge to the P&L would be disallowed for corporation tax. A more common method would be to specifically asses each loan:
Example 2.
A lender has £1m of principal, interest and fees owed to it at the balance sheet date. The lender reviews each customer and refers to recent communication and specific payment history. As a result the lender specifically provides 100% against some customers who have “gone away” and perhaps much smaller % against those that appear to be slow payers. The individual provisions are aggregated and the lender ensures that the bad debt provision in total is adjusted in the balance sheet with the other side going to the P&L.
The above example is of a specific provision that tends to be allowed for corporation tax. Ensure that you work with your tax advisers to obtain optimise this.
Whilst reviewing your bad debt provisions (whether general or specific) bear in mind that you have the advantage of hindsight, experience, case history, market performance to consider.
Where you might be producing your financial statements, say, 6 months after your year-end then clearly you have the advantage of being able to assess what receipts have come in during this 6 month period.
Many lenders have needed to change their business model over the last year. This will have had an impact on default rates and consequently bad debt provisions. If this is the case then ensure that you segment your loan book into “old model” and “new model” and assess your provisions accordingly.
Remember that if for ease you have applied an approximate % during the course of the year; then you will need to spend some time to re-calculate the provision at the year-end. Also remember that there may be the need for a large adjustment between the approximated % and an accurate provision. Therefore it would be recommended that you build into your monthly accounting the ability to calculate more accurate provisions. This way no surprises will arise.
Disclosure requirements will vary depending upon the size of your company; materiality, and your willingness to be open. Generally it is best to provide more disclosure and information, so as to inform the reader better. The readers tend to be credit agencies, funders, potential acquirers and suppliers. All of whom would gain a more positive appreciation if the financial statements were clear.
Should you be an alternative lender and have any concerns after having read this article then do not hesitate to contact Andrew Millet at
[email protected]. Andrew Millet is a director at Wisteria Chartered Accountants who has sector experience working with alternative lenders.