Recording Financial Losses (#398)
/I’m going to focus on the uncertainty associated with losses. A loss can come from all kinds of things, like a bad debt, or damaged inventory, or an asset impairment, or a decline in the value of an asset. In many cases, recording an accurate loss is not simple.
Bankruptcy Losses
For example, a customer goes bankrupt, and your invoices issued to it will be paid from the customer’s remaining assets. What’s the amount of the loss? That’s a good question. It could be many months before the customer goes through bankruptcy proceedings and figures out what percentage of each invoice it can pay. In the meantime, the amount that you recognize as a loss is nothing more than a guess, because literally no one knows. A lot of businesses will take the worst view and write off the whole receivable, on the assumption that nothing will be paid from the customer’s assets. If something is eventually paid, then it’s separately recognized as an offset to the loss on some future date.
But that’s not the only option. What if you get an offer from a hedge fund to buy your claim to that receivable for a discounted amount? If you take the offer, then you give up your rights to any eventual payout, but then you finally have certainty as to the amount of the loss.
Here’s another possibility. What if it’s such a large unpaid receivable that you end up on the creditors’ committee that oversees the bankruptcy? In that case, you’ll see the customer’s financials every few months, and will be able to guesstimate the amount of the eventual payout – which will change in each successive month as the customer’s numbers fluctuate.
In this situation, you’re more likely to recognize a best guess at the amount of the loss right away, and then keep adjusting it up or down in later months as the numbers change.
In this first example, you can see that the amount of the loss to be recognized is not entirely obvious, and might require some ongoing adjustments. Let’s try another one.
Inventory Losses
A online retailer has a large stock of consumer goods that are damaged when a hailstorm hits its main warehouse. It’s reasonable to assume that a loss will be recognized. The trouble is, how much of a loss? It will take some time to sort through the inventory and figure out how much can still be sold, and how much has to be thrown out. There’s some uncertainty here, because it might also be possible to rework some inventory for sale, or maybe you can sell it off to a discounter. In either case, you won’t have a firm loss number right away, because it takes time to rework the goods or negotiate a sale. In this case, you’ll record your best guess at a loss, and then adjust it later when the numbers firm up.
Noticing a trend here? You’re supposed to recognize a loss right away, but it’s not always possible to do so. Let’s try a third example.
Hazardous Waste Remediation Losses
Your company bought a property a year ago, and it’s just come to your attention that there’s hazardous waste on the property that’s leached into the groundwater. What’s the amount of the loss? Good question. The basic rule is that you recognize a loss contingency when it’s probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Your first steps are to hire a consulting firm to estimate the remediation cost, and a law firm to figure out if you can stick some of this cost on the party that sold you the property.
Given these facts, can you realistically recognize a loss right away? Probably not. There’s definitely a liability, but the amount is completely uncertain. The most likely scenario is that you recognize a loss in the amount provided by the consulting firm, and then offset it in a year or so once the lawsuit against the former property holder has been settled. And on top of that, the cost of the actual remediation is probably going to differ from the amount provided by the consulting firm, so there will be further adjustments to the loss over time.
Asset Retirement Loss
Yet again, there’s uncertainty about the loss, and it will take time to resolve. Let’s do another one. A manufacturing business has an older machine on the premises, and the engineering manager has decided that it’s obsolete and needs to be replaced. So, do you recognize a loss on its remaining carrying value right away? Well, no. You’re still using the machine until a replacement machine is installed.
If the engineering manager decides to scrap the old machine as soon as the new machine is installed, then you know the amount of the loss, and you know roughly when the new machine will be installed, so it seems like loss recognition should occur as soon as the new machine is operational. Or, is it? What if the engineering manager wants to retain the old machine as a backup, in case the new one fails? In that case, there is no loss, just ongoing depreciation of the machine.
Not so simple, is it? Let’s finish with one more.
Natural Disaster Loss
You have a production facility that sits on a fault line, and a nice, big earthquake messes it up. An initial repair estimate is a couple of million dollars, and your insurance company is willing to reimburse you for three quarters of that amount. The initial loss entry is probably for the difference between those two figures. But is that the end of the loss? No. You’ll probably keep arguing with the insurance company about the payout, so that number will change. And, the actual repair to the facility is bound to be different from the estimate. In short, and once again, the amount of the loss will change over time.
What’s the lesson from all these examples? That the first loss entry is merely a best guess. With any luck, that first entry will be sort of, kind of close to the actual amount of the loss that’s eventually recorded. But that might not be for months, or even a few years. In the meantime, you have to keep reviewing the loss-creating situation to see if the cumulative loss to date needs to be adjusted. If that adjustment is material, then you have to keep right on making adjustments for as long as it takes.