How to use accounts to avoid bad debts
How to use accounts to avoid bad debts and get paid, concerns review of certain key features that seem to sprout with some frequency in filed annual accounts at Companies House that I see when companies are insolvent and subsequently may go into some form of insolvency.
From the outset let me say that I acknowledge the remarkable times that we are currently facing at the moment. Nothing in this post is intended to avoid and or bypass consideration and or recognition of the fact that this is going to be a very difficult time. Such times reasonably require empathy and consideration. The interests of the community at large are paramount and we must work together. The normal approach to credit management ought to be reflected upon and forbearance afforded save arguably where fraud has arisen and or continues.
However, challenging decisions will still inevitably be faced in the weeks and months ahead, including by those seeking to determine their credit management approach to trading risk assessments. We simply do not know how trading patterns are now going to develop. Nevertheless this post may have greater relevance when a time of greater normality returns, hopefully for us all in the not too distant future.
It is nevertheless a good idea to keep a look out for these issues as they seem to occur time and time again. A proactive review of a customer’s historic accounts might give an extra dimension to your credit and risk management. It might prove useful in determining when you might wish to take the gloves off and issue a winding up petition.
This post looks at a type of issue that might not necessarily be picked up by credit reports. You can do this yourself at no cost. You just have to know how to train your sights on the right numbers and look a little further than the ‘headlines’.
This is not going to require you to deploy your Stakhanovite forensic skills or to get out the sharpest tools from your credit management toolbox. This can be as fast as reviewing a credit report you might rely upon.
It is also not rocket science either but you have to know where to look and then what further investigation might be required.
When I am asked to look into and assess a company’s financial position and investigate historic conduct, I will typically look at patterns of behaviour. Humans have been said to be creatures of habit and that is often reflected in accounts, in a pattern of behaviour reflected when the numbers are crunched out.
I am going focus in this post ‘how to use accounts to avoid bad debts’, on Other Debtors in accounts and more particularly when a Director’s Loan Account is included within Other Debtors in a set of accounts.
It is acknowledged that the company that I have chosen to use only as an example for the numbers it provides from public records, has gone into insolvent liquidation. I have picked on this company as an example only largely chosen at random. It is often suggested that caution should be deployed when using hindsight. However, nevertheless looking at history can be said to assist us plan for the future. We know it can and often does repeat itself.
Recognition of Assets on the Balance Sheet
At the heart of this post on how to use accounts to avoid bad debts is consideration of assets that support a company’s balance sheet and show it to be solvent.
The guidance on recognition of assets on the balance sheet in general terms is set out in paragraph 2.27 of Financial Reporting Standard 102 (“FRS 102”) which says:
“Recognition is the process of incorporating in the statement of financial position or statement of comprehensive income an item that meets the definition of an asset, liability, equity, income or expense and satisfies the following criteria: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured reliably.”
Recognition of current assets such as debtors, who owe money to the company or in the case of fixed assets, where a flow of economic benefit for the company is anticipated, is subject to the requirement to impair them by virtue of paragraph 27.5 of FRS 102:
“If, and only if, the recoverable amount of an asset is less than its carrying amount, the entity shall reduce the carrying amount of the asset to its recoverable amount. That reduction is an impairment loss.”
In other words if an asset is in effect worthless to a company, it should be written off and not carried through continuously year on year on the balance sheet.
Other Debtors and Overdrawn Directors Loan Accounts
The use of accounts to avoid bad debts and get paid can be considered by a review of Other Debtors on a balance sheet and in the notes to the accounts.
What are Other Debtors. Other Debtors being distinct from Trade Debtors (debts due to the company from its trading customers) are ‘other’ debts due from parties who owe money to the company. The key distinction is that such parties who owe money to the company will not usually arise from ordinary trading activity.
A classic example of an Other Debtor that I will focus on is that of a Director Loan ie. money or consideration provided by the company to its Director. When a company lends money to one of its Directors over and above what the Director might be owed by the company, an overdrawn Directors Loan Account will arise. It is in essence no different to being overdrawn at the bank.
Let’s examine the accounts of a company that has recently gone into Creditors Voluntary Liquidation to focus on a real example from public record.
The company I have chosen is purely to source some real numbers, not to pass judgment on the company in question. The company has been chosen at random using criteria that it has gone into Creditors Voluntary Liquidation this year and is one that has filed accounts with some of the features that I want to consider. It is Holbeach Recruitment Limited (“HRL”).
The Insolvency Notice for HRL shows that it entered liquidation on 27 February 2020.
The last accounts for HRL were filed for the year ended 31 March 2018. The balance sheet was as follows:
These accounts appear to disclose a modest Net Assets Less Current Liabilities figure of £7,917 for the year ended 31 March 2018. Further, if you look at the comparative figure for the previous year, you will see that the company had filed an insolvent balance sheet with Net Assets of -£7,769.
Now if we train our sights on Debtors for the year ended 31 March 2018, there is a figure of £248,289. You will see that Debtors has been referred to in a note to the accounts being Note 5.
Debtors represent the largest assets of the Company. If there were to be more than around £8,000 of balances within debtors that for any reason might have been uncertain from the point of view of recoverability, that arguably could have tipped the balance sheet into insolvency at 31 March 2018. Let’s have a look at Note 5 to see how debtors are broken down.
Within Note 5 on Debtors are a series of balances for the year ended 31 March 2018. The first point to note is that the Directors’ Current Accounts are overdrawn by £53,920. That means that certain of the Director(s) owed the company that sum at 31 March 2018. Now if you focus on the same figure for the year ended 31 March 2017 you will see that the figure increased from £34,401.
Where there is mention in Debtors of a Directors Current Account you may often see another note showing you further information on the same. In the case of HRL you can see at Note 7 this further information:
Note 7 shows a Director of the company as at 31 March 2018 had an outstanding balance of £53,919 due to HRL, which save for a £1 difference matches the figure shown in Debtors at Note 5. What the note appears to show is that the loan account of the Director had increased from the previous accounts due to “Advances” being made by HRL to the Director, over and above the level of any repayments. For the year ended 31 March 2017 the company advanced to the Director £26,322 and for the year ended 31 March 2018 it advanced a similar sum in the amount of £26,022.
The question which might arise for someone to consider is whether the amount shown as overdrawn by the Director Loan Account would be repaid. It has to be remembered that this is where speculation is involved in making risk assessment judgments. Accounts are creatures of historic reporting of transactions which have happened, ordinarily based on historic cost accounting. Speculation is future prediction. An independent reader of the accounts does not know if this balance will be repaid.
The intention and or ability of a Director to repay an overdrawn loan account may well validate a Director’s Loan Account being shown in Debtors but that does not mean it will be repaid. When looking to assess and speculate about the value of a current asset such as Debtors, I might ask the question: What is the risk based on the information that I can see that suggests this balance might not be recovered and what is the wider impact of that.
If I am uneasy about it a) would I want to trade with such a company and or b) if I have traded with such a company do I want to continue and or c) if I am owed money do I want to do something about it more quickly to vary my perception of the risk of suffering a bad debt.
Certainly from a balance sheet declaration by a Director, asserting the truth and fairness of the accounts, it ordinarily has to be assumed that a) there will be an intention to repay an overdrawn Director’s Loan Account and b) a Director is in a position to repay it.
If we turn to look at the historic pattern of the Director’s Loan Account for HRL, we see the following based on the public record:
It can be seen that since 2015 when it started as a relatively modest figure, that year on year the overdrawn Director’s Loan Account had been increasing.
Then if we then scroll forward to the point of liquidation, the Statement of Affairs as at 17 February 2020 showed the following in respect of the assets:
It can be seen that the Director’s Loan Account was listed at book value as £56,537 with an Estimated to Realise value referred to as “Uncertain”.
One might wish to consider and conceivably speculate, about whether or not if you had another company with such an overdrawn Director’s Loan Account shown as an asset; as part of your risk assessment would you want to recalcuate and assess the underlying net asset position as a result.
Provision for a Director’s Loan Account Balance
The position I am exploring in this post on how to use accounts to avoid bad debts, is the matter of risk. I am speculating that notwithstanding the accounts declaration of a balance due and owing by a Director for example, can a risk still be factored into a company’s strategy to avoid bad debts and its credit management procedures.
If (and I do say if because it is simply unlikely to be known) there is no intention or no ability to repay a Director’s Loan Account, then the argument can be that recognition of a Directors Loan Account on the balance sheet should not happen.
In general terms on the one hand there is the argument that a Director is liable to repay an overdrawn loan account; on the other hand the probability that the company simply would not receive it (in circumstances where there might be no intention and or no ability to repay it) means that by virtue of paragraph 27.5 of FRS 102 (referred to above), it should not be shown on the balance sheet as a debtor balance.
Impact on the Balance Sheet of an Overdrawn Director’s Loan Account
If you were to be concerned about a disclosed overdrawn loan account shown on a balance sheet for any reason, then you might consider doing your own calculations with it in effect stripped out.
If this were to tip the balance sheet into insolvency on a Net Asset basis then it might give you food for thought about undertaking further investigations before formulating your supply of credit and risk management approach, including but not limited to whether or not you might take enforcement action sooner in a normal trading marketplace.
In the case of HRL, if the overdrawn director’s loan account was for the purposes of calcuations only, removed from the balance sheet as at 31 March 2018, then the following position could be factored into a risk assessment:
The question is would such an issue have caused you to reassess your risk and do your existing credit management and risk assessments take such factors into account.
Conclusion and Observations
The same principles in relation to overdrawn directors’ loan accounts equally can apply to loans and advances to connected parties. These can also appear within other debtors, in notes to a company’s balance sheet. Unlike an overdrawn director’s loan account, you can conceivably more easily source public records to seek to assess such balances. You can look at the accounts of those connected companies at Companies House. This may be the subject of a further post on this topic in the future.
In the meantime this post is really intended for a normal economic marketplace in which normal considerations would apply to credit and risk management, in dealing with prospective new customers and or dealing with existing clients. This is something that we currently do not have the luxury of. In cases of fraud both now and even during these remarkable times this post will conceivably remain relevant.
First and foremost in these very challenging and difficult times that we live in at the moment look after yourself and of course each other.
Disclaimer: This post “How to use accounts to avoid bad debts” is not legal advice and not to be relied upon as such. No liability is accepted by the author or the author’s firm, Oliver Elliot Chartered Accountants, for any reliance placed upon any aspect of this post. You should seek independent professional advice on the facts of your case. In addition to that, nothing in this post seeks to challenge or impugn the integrity or accuracy of any of the numbers in the real life examples selected. Such selection has been chosen to assist the reader only. This post for the avoidance of doubt is not in any event about the accuracy of the numbers in any accounts chosen; it is about risk assessment that might be speculated upon.