PROVISION FOR BAD DEBTS: A STRATEGY FOR ENHANCING BUSINESS GROWTH IN SMES

CHAPTER TWO

LITERATURE REVIEW

2.1Conceptual Review

2.2Credit Management

Credit management refers to the overall procedure of loaning beginning from inquisitive about the prospective debtors up to recuperating the sum approved (both principal and interest). In the investment (i.e finance) sector, the management of credit facility gets crucial with critical actions for example, accepting credit requests, credit appraisal, its approval, monitoring, and of-course recovery of non-performing loans ifit goes bad (Shekhar 1985). The issue of credit management has a significant complication both at the smaller scale and large scale level. At the point the facility is designated ineffectively it tends to increase expenses to lenders, dissolves the assets, and minimizes financial institutions adaptability to diverting assets towards elective exercises. In addition, the higher the facility, the higher the hazard related. The issue of advance default, comes about because of poor credit administration, lessens the loaning limit of the financial institution. Likewise restricts new candidates' entrance to the facility as the financial institutions income administration becomes problematic and fragile. However, it might bother the ordinary inflow and surge of asset.

2.3 Procedure of Credit Management

The procedure loan administration begins from evaluating the worthiness of the client in-terms of his repayment behavior and his business practicality. It is critical if the bank broadens or expands the credit ceiling towards a specific client. Competent credit administration looks to not just ensure the bank or any money related organization required from conceivable misfortunes, yet in addition shields the client from making more obligation commitments that can't be settled in an auspicious way. At the point when the procedure of credit administration works proficiently, everybody included advantages. This study considered Customer Evaluation as a variable of Credit Management.

2.4 Customer Evaluation

The initial phase in restricting credit chance includes putting potential applicants to series of test, this is to guarantee the eagerness and might to pay back as at when due. Most microfinance Institutions makes use of the 5Cs of credit to evaluate a client as a potential borrower or not (Abedi, 2000). This 5Cs help FIs to effectively give credit facilities, as the customers become subjected to the this test, they know more about the customer in terms of character, capability, capital, condition and collateral.

A credit expert regularly gives essential consideration regarding the initial two C's- character and capability- since it speaks to the fundamental prerequisites for stretching out the facility to a candidate. The thought of the remaining C’s-Capital, condition, and collateral tends to be critical in organizing the facility and settling on its last hinge of approval, this is influenced by the loan investigator's involvement and discretion.

As indicated by Golden and Walker (1993), he identified likewise five Cs of awful obligation; that speaks to prepare for a specific end goal to help avoid issues. These are: Complacency, Carelessness, Communication-breakdown, Contingency, and Competition.

The model for scoring credit is an arrangement system that organizations assembled from applications methods for fresh or existing facility; these are used to allot potential customers to great or terrible facility risk classes (Constantinescu, Badea, Cucuci & Ceausu 2010). Inkumubi (2009) noticed that initial capital fund as major stumbling block for business people especially small-scale businesses attempting to get capital. This is essentially applicable to little scale ventures, early business entrepreneurs that have little or no cash to use as capital; or with no collateral to be used as security for the credit facility.

2.5 Some Problems Facing Small-Scale Enterprises in Nigeria

According to Ekhator (2001:32), the major problems of small-scale enterprises sometimes arise from the nature and characteristics of the enterprise. He therefore classifies their problems into two main categories:

1. Problems inherent in the small enterprise.
2. Problems arising from weak official sustenance.

Babajide (2002:17) strongly opined that small-scale enterprises major problem does not primarily depend on avenues of sourcing funds but its accessibility. Even after 1970, when the government diverted from the industrialized to focus and lay pre-eminence to small and medium scale enterprises from import substitution and large scale industrialization, it has been series of promotions, financial incentives by successive governments to promote small-scale enterprises. The capitalists are also well-known and her exploits recorded cannot be equated with the drive and energy ventured into it.

Mordi (2002:35) believes that funding is not the major problems of small-scale enterprises. He prefers to view the situation from two perspectives. According to him, most small-scale enterprises find it difficult to differentiate between the owner of the business and the business itself. He said that many small business managers run the business without some shape of financial duty and show off gross lack of knowledge about the need to seek equity participation that is capable of lifting the enterprise to more heights but this is grossly neglected.

On the policy side, the fundamental problem he sees is the hassle of offering marketing protection for small- scale enterprises. He stated that the authorities do not provide market protection for small-scale companies in the country. Taking the local manufacturers into consideration, they face stiff competition from their overseas counterparts, who produce who produce beneath economy of scale that give them unfair advantage. An example is the textile industry in Nigeria. Mordi cited that the local wax industry in Nigeria was formerly satisfactory when compared to others and sold well inside the marketplace until Hollandie wax come into the its boarders and was seen as been superior or been modern in flip, it introduced decline to the rate of Nigerian wax. He stated so many other reasons to buttress his belief that fund is not the major problem because if you give funds for somebody to produce and such products are not been bought, especially when the government happens to be its largest buyer, market is not been created for him.

Another area the government can assist small-scale enterprises, is in the area of “encouraging patronage”. He said that it is not simply enough for the government to champion the “produce more and buy made- in- Nigeria goods” crusade. He said that the government should take practical steps by patronizing small-scale enterprises to serve as morale booster. He said that a lot of keyboards used in churches and other places in Nigeria currently are products of small-scale enterprises in developed countries. He recalled that when some small-scale enterprises in Japan built the keyboard, the government made it compulsory for all public schools to purchase them for the purpose of learning music. Thus, enabled its manufacturers to add more beautiful notes before they were shipped to Nigeria. Small-scale enterprises expert, however, observed that the government appears to have come to grips with the situation by taking a long over-due step to ban the importation of some products such as turkey, beer, bottled water and cigarette lighters.

According to Obitayo (2001:16), small-scale enterprises like large scale enterprises assemble finished goods and depend critically on imported raw materials and equipment, and thus suffer from the same problems. But the size, characteristics and isolation of small-scale enterprises tends to make them vulnerable to these constraints which has less effect on the large ones. Hence, the small-scale enterprises tend to record a higher rate of business failure.

Despite efforts given at availing capital to small businesses and ensuring that the nation’s regulatory framework is lenient with the termination of stringent policies that are hazardous to the stable growth and development of small businesses, there still remains areas that specifically have not been attended to appropriately. These areas are discussed below:

2.5.1 Poor Access to Credit Facilities

Finance happens to be one of the critical needs of small-scale businesses or enterprises (SSE) to establish production plants, technological advancement, larger production etc. this also has been identified as their basic problem, reflecting on the imperfect market. A lot of Small-scale Enterprises (SSEs) tend to have limited link to institutional finance, not excluding the short-term working capital to meet the ever dynamic needs. Well, since financial institutions are risk adverse, the bad performance of small-scale enterprises (SSEs) and the high risks and transaction cost commonly linked to these small scale facilities have made them (financial institutions) unlikely to lend to small-scale enterprises (SSEs).

Other limiting factors include small-scale enterprises (SSEs) and their required equity contribution, the securities needed by the financial institution to recoup loan amount in case of default, shortage of long term loans, restrictive monetary policy and high cost of borrowing. The wholesale liberalization of the financial sector and the tight monetary policy stance which addressed excess liquidity has resulted in rising interest rates on loans. The specialized target credit scheme such as NERFUND and SME I and II are some of the examples provided by the federal and different state governments but they also have encountered difficulties due to acute budgetary constraints and lack of counterpart funding and have to a limited extent, succeeded in addressing the funding requirements of small-scale Enterprises (SSEs).

2.5.2 Infrastructure Constraint

The pitiable state of the country’s basic structure has stayed basically stagnant, and incompletely dictates the development limits of Small-scale Enterprise. Creative actions in industrial sub-division are categorized by flawed structure, relentless electricity outage and inefficiency of credit limits which adversely affect small industries. Also, the inadequacy of provision of basic amenities, such as the telecommunications, transportation, and poor water flow indicates one of the utmost lacks to small-scale industries improvement.

Most Small-scale Enterprises (SSEs), help to reserved provisioning of these facilities at great costs, thereby reducing the available funds of their actions. A World Bank contemplate (1929:3), estimated that such cost accounted for 15% - 20 % of the cost of establishing small-scale enterprises in Nigeria. It is likely to be much higher today, given the high level deterioration of the basic infrastructure. Contemporary evidence has shown that the burden of the provision of infrastructure facilities is much heavier on small-scale enterprises than the large enterprises.

2.5.3 Technical Constraint

Like large enterprises, small-scale enterprises (SSEs) requires current administrative abilities to source assets which are scarce in the nation., hence, the collaboration of the government and private sector ensures needed relieve schemes which primarily caters for the gap in the small-scale industry. In line with that, the National Association of small-scale enterprises (NASME), therefore has to work with the industrial development-center_(IDC) for the sole purpose of this.

2.5.4 Troubling Macroeconomic Variables

Tough Macroeconomic conditions in Nigeria are badly influencing the kick-off of sound Small-scale industry and are also threatening the development and growth of the small-scale businesses. Majority of Small-scale Enterprise are pondering on the element of been susceptible to the macroeconomic instability and policy changes. Other sources of uncertainty that have impacted negatively on small-scale enterprises include high and unpredictable inflation, price instability, foreign debt harden and service obligation.

2.3.1.1 Theories of Bad Debts

While there is no specific definition of a bad debt, it can be generalized as follows: a debt that occurs when a firm believes that a debtor is unable or unwilling to pay and the business will never be able to recover the money owed (Ireland, 2005). It is, therefore, a debt that cannot be collected, or one whose collection would be uneconomical to pursue. Generally, in these circumstances the bad debts are written off, which is essentially a cancellation of the debt to remove its effects on the accuracy of the statements. Only specifically identified amounts are written off as bad debts.

Speaking of ‘bad debt estimation’, however, is a misnomer; we are actually speaking about ‘doubtful debts’, or those circumstances wherein a firm believes there is a decreased likelihood (often substantial) of a debtor paying his debt, for various reasons. It is essentially grounded in two generally accepted accounting principles. The first is the matching principle, wherein revenues are recognized when earned and not received, and expenses are recognized when incurred, not paid. This method of recording matches income to the period it was generated without relying on the actual timing of cash flows. The second is the objectivity principle, which says that the value of balance sheet items such as the accounts receivable should reflect their expected realizable value (Prosser, 2003).

Matching concepts is a generally accepted principle. The matching rule dictates that "Revenues must be assigned to the accounting period in which the goods are sold or the services performed, and expenses must be assigned to the accounting period in which they are used to produce revenue". Under the allowance method, losses from bad debts are matched against the sales they help produce. Under direct write-off, bad debts is usually recorded in a different accounting period from the one in which the sale takes place, the method therefore does not conform with the matching rule (Needles, et al., 2007).

This distinction, however, creates a dichotomy in how such debts are handled. Bad debts are generally written off, which simply involves deducting the amount of the bad debt from the debtors balance directly, with the company incurring an expense (“Bad Debts Expense”) in the process. This is the "direct write-off" method of recognizing bad debts. Books in accounting classify this practice as not within the generally accepted accounting principles, and therefore is not acceptable. General practice dictates that bad debts are written off soon as they are identified. On the other hand, providing for doubtful debts involves creating an account called “Allowance for Doubtful Accounts,” which is a contra account to the Accounts Receivable on the balance sheet. The rules for creating this provision (% of Credit Sales, % of ending Accounts Receivable, Ageing of Accounts Receivable, etc.) vary, but the basic concept is to allow for debts that may be potentially written off in the future to match the revenue at the time the revenue is recognized. This is the more acceptable method and is within the generally accepted accounting principles. In this case, a doubtful debt that becomes bad is written off with a debit to the allowance account, and a credit to the accounts receivable. In both methods the balance of the debtors account is reduced, however, the timely effects of the bad debts expense in the income statement may vary and may be in contrary to the matching principle.

Bad and doubtful debts share many similar characteristics, the only real difference being their level of collectability. According to Prosser, the general rule is that any debt greater than 6 months must be carefully considered as a bad debt, though a debt can become ‘bad’ at any time within its life cycle depending on the circumstances, while debts can be classified doubtful when a debt is aged 90 days or more. Additionally, bad debts are generally the result of objective evidence, i.e. when there is proof or advice from an independent third party regarding the uncollectable debt, while doubtful debts are based on subjective, though not entirely arbitrary, estimations.

In 1990 Gerard Scallan tried to propose using Markov chains, a complicated statistical tool, as a new approach to bad debt modeling. Without going into the mathematical intricacies, the model defines debts to be in any of a set of “risk states,” and a debt can jump from one state to any other—or remain put—in successive periods. Using this process, Scallan argues, could not

only project bad debt but also simulate what-if scenarios of changing various credit policies in relation to bad debt. However, no data has been found regarding the use of such a model in current accounting practices.

2.3.1.2 Practices in Bad Debt Estimation

When and how bad debts are recognized under the law varies from country to country, and so do the policies regarding the reporting of such write-offs and estimates. The methods used in estimating doubtful accounts also differ depending on the nature of the company or business. These findings, policies and practices are briefly outlined below.

According to research done in the United Kingdom, SMEs in particular write off an average of £14,000 in bad debt per annum, which means that at a 5% profit margin they would have to make additional sales of £280,000 to make up for the loss. (TAK-Credit Management, 2009). According to Williams, Charles & Scott Ltd (2011), an independent collection service firm based in New York, a business with a net profit of 2% experiencing $100,000 in write-offs would require an additional $5,000,000 in sales to offset the loss of profit in write-offs. In any case, these show that bad debts do not simply affect a company’s cash flow and bottom line performance, but sales and marketing efforts as well—a crucial issue for start-up or growth companies such as SMEs. Thus, effective management of receivables is crucial for the success of any company with a credit policy.

In “Avoiding Business Failure: A Guide for SMEs,” a paper published by the European Federation of Accountants (FEE, Fédération des Experts ComptablesEuropéensin French) in 2004, impending bad debt was identified as one of the possible major causes of business failure among SMEs. According to the report,

“The main problem for SMEs, though, may be in actually identifying potential bad debts and being able to reduce them. In many SMEs, there will not be an in-house credit collection department which is able to undertake regular credit control activity and follow up matters of going-concern. For this reason, bad debts may have a more dramatic impact on SMEs than on larger businesses.”

The findings are relevant in light of the fact that in 2004, 99% of all businesses in the European Economic Area are SMEs, with two-thirds of the entire labor force employed there.

In terms of the methods used by businesses in general, a quick survey was conducted by Credit Research Foundation in 2002 covering a wide variety of industry sectors in the United States. It recognized three generally accepted procedures that may be used in estimating doubtful debts, namely the Percentage of Credit Sales, Percentage of Ending Accounts Receivable, and Aging Accounts Receivable, while the direct write-off was recognized for situations where it is impossible to estimate the amount uncollectible from a period with reasonable accuracy. The survey yielded the following key points:

Out of 160 respondents (30.5% response rate), 26% use the direct write-off method, while 74% use the allowance method.

Of those who use the allowance method, 30% use Percentage of Credit Sales, 28% use Aging Accounts Receivable, and 15% use Percentage of Ending Accounts Receivable.

89% of firms have not altered their estimation methods over the last five years.

In writing off debts, 65% wait for factual evidence of an inability to pay while 35% write off as soon as a reasonable estimate of loss can be established.

87% of the firms using the direct write-off method write off the receivable as soon as it is clear that the account is uncollectible, as opposed to writing off at the end of the year.

The survey yields two insights. First, that as an estimate, there is an element of subjectivity with regard to the recognition of bad debts, which therefore affects the reported value of profits and the Accounts Receivable account. Second, since an allowance in effect writes-down Accounts Receivable to a probable liquidation value, the nature of management also affects how much allowance is made and reported. Conservative management would prefer to establish a high allowance, which is advantageous if a series of insolvencies are encountered, but understates profits as a result of the large amount.

In terms of bad debt estimation, the practices vary. According to the most recent IFRS, under IAS 39, the system of allowances has been replaced by the recognition of impairment losses. An impairment loss adjusts the carrying value of a receivable to its fair value or recoverable amount and may be recognized only as a result of the occurrence of a loss event. The amount of the loss is the difference between the receivable’s carrying amount and the present value of expected future cash flows discounted at the receivable’s effective interest rate (recoverable amount). Under the French GAAP, such a loss event includes failure to pay a single installment in 90 days, while historical loss data can be used to estimate the impairment loss. This difference between the allowance previously allowed and the impairment loss estimate is recorded as an adjustment to retained earnings.

In the United States the Internal Revenue Service (IRS) no longer allows businesses to use the allowance method in accounting for bad debts, instead requiring the direct write-off method (Day, 2008). However, businesses are usually left free to judge when an account receivable is determined to be uncollectible. Auditors ideally provide a check and balance for these estimates, often requiring them to provide substantial reasons and proof for write-offs, but as has been seen in the current financial climate, when auditors collude with businesses the credibility of financial reporting may be put into question. An interesting case study on the SEC vs. California Micro Devices Inc. actually deals with this extensively (Capriotti and D’Aquila, 2008).

Another factor for varied practices would also be the nature of the firm in question. Schools, for example, have very specific methods of recording and recognizing losses (University of Queensland, 2009 and California State University, 2008). For big companies which sell products or services on credit to other businesses, a process called debt factoring is often undertaken, wherein the company sells its invoices to a factor who pays an advance and then works on behalf of the business to collect money owed by customers. Once the customer settles an invoice to a factor, the factor releases the remaining balance to the company less any fees. This allows them to manage their receivables better (Business Link, 2009).

Nonetheless, in some places allowances are still allowed. In Nova Scotia, for example, adjustments to allowance accounts and write-offs require approval from the Ministry of Finance. The account titles used vary slightly, and accountants are required to prepare reconciliation statements showing the adjustments to the allowance account and the method used in estimating bad debts.

In the Philippines, according to Sec. 34 (E) of the Tax Code, the following are the requisites for deductibility of bad debts:

1. There must be an existing indebtedness.
2. The debt must be ascertained to be worthless, as when the debtor is insolvent.
3. It must be actually charged off within the taxable year.
4. The debt must be connected to one’s profession, trade, or business.

In non-profit organizations in the Philippines, bad debts are usually written off at year- end according to the guide published by the Asia Pacific Philanthropy Consortium in 2006. However, not much data is available for what practices SMEs might generally have, and how these might differ from other industries.

2.3.1.3 Implications on Financial Reporting

Generally, most of the literature states that the method of bad debt estimation is mostly affected by its implication on taxation. It could be said that writing off is practiced depending on the tax benefit gained by the company. Writing off debts decreases income, therefore decreasing the amount of tax, and the practice is one of the more well-known tax-saving tactics and strategies in any nation. During seasons of recession and economic downturn, companies have an incentive to write off debts when they are experiencing low profits. However, companies generally only write off when there is a tax benefit to be gained; even in recessions, firms experiencing a loss are not likely to write off debts until it is advantageous for them to do so.

This practice of manipulating figures on the balance sheet and income statement is part of what has been loosely defined as ‘creative accounting’. Since the accounting process inevitably involves matters of judgment and resolving conflicts between approaches to the presentation of financial transactions, there is a flexibility, which provides opportunities for manipulation and misrepresentation. These could seriously distort perceptions of the business, and circumstances where estimations are necessary, as in determining how uncollectible bad debts can be, are especially prone to be in such ethical gray areas (Amat et al., 1999).

However, laws tend to limit this by taking a more stringent approach to the estimation and write-off of bad debts, often requiring multiple objective layers of proof before allowing bad debts to be deducted. In New Zealand, penalties have been made more stringent in taking up ‘abusive tax positions’ in light of alarming tax-evasion trends in the property development and SME contexts. The general principle is that the less estimation an accountant makes, the less propensity there is to manipulate figures to the business’ undue favor (Johnson, 2010).

Bad debts generally cannot be avoided, as they are a resultant act of granting credit, and therefore the management question is how to minimize the costs thereof. The level of bad debts may also have a direct correlation with the lending practices of the entity involved and the competitive nature of the business they operate in. For SMEs in particular, bad debts are influenced by the standards adopted by other players in the market. However, the principles of good credit practice are constant regardless of the nature of the market.

2.6 Theoretical Review

2.6.1 Credit Risk Theory

This study adopted credit risk theory by Melton (1974); this theory was adopted by the researchers because it holds an important role in credit management. In spite of the fact that individuals have been confronting credit risk as far back as early ages, credit risk has not been critically examined until late 30s. During the Early writing up before 1974, for a customer to be able to access a loan facility, the financial body tends to adopt a conventional actuarial strategy for credit risk. This is where significant trouble lies, in their entire believe or reliance on chronicled information. As of not long ago, there were but three quantitative methodologies of evaluating credit risk: organizational approach, diminished shape evaluation and deficient data approach. (Crosbie. 2003)

Melton (1974) announced the credit chance hypothesis generally called the structural theory which is said the default occasion gets from a company’s advantage development displayed by a dispersion procedure with steady parameters. Such models are normally characterized re normally characterized “structural model” and it is based on variables related a specific issuer. An advancement of this field is spoken to by resource of models where the misfortune contingent on default is exogenously particular. In these models, the default is exogenously particular. In these models, a debt can occur all through the lifespan of a security and doesn’t occur when it’s due (Long staff and Schwartz 1995).

2.7Empirical Review

Pyle (1997), researched on bank credit management and he discovered that banks and other financial institutions need to reach expected administrative necessities for chance estimation and capital. Be that as it may, it would be unwise to imagine that day to day business is the purpose of setting up a good hazard administration system. It was held, chiefs require dependable hazard measures to guide funding to exercises with the best hazard/compensate proportions. They require gauge of the measure of potential misfortunes to remain inside cutoff points forced by promptly accessible liquidity, by leasers, clients and controllers. They require instruments to screen positions and make motivations for judicious hazard taking by divisions and people.

Nagarajan (2001) investigated hazard administration for micro-finance establishments in Mozambique and he found out that hazard administration tends to be a dynamic procedure which preferably is created amid typical circumstances and tried in the wake of hazard. This allows cautious arranging and responsibility on part of all partners. Urging to take note, that it is conceivable to limit dangers related misfortunes via persevering administration of portfolio and income, by providing hearty and sound institutional framework with talented and skilled HR thereby instilling wonderful customer interaction, via powerful relationship with partners.

Achou and Tenguh, (2008) additionally led look into on bank execution and credit chance administration found that there is a noteworthy connection between money related foundations execution as far as productivity) and credit hazard administration. Good loan hazard administration spurs better judgment. In this manner, it is of pivotal significance that budgetary foundations hone good credit hazard administration and shielding the benefits of the organizations and ensures financial specialists ‟interests. This is additionally valid for small-scale back organizations. Strategy utilized by the scientists is blended research technique.

Credit hazard radiates from the way banks manage people, corporate, money related bases or supreme materials. A poor portfolio may haul in fluidity and also credit chance. The point of credit hazard administration is to amplify a bank’s chance balanced rate of return by keeping up credit chance introduction inside adequate limit. The effective administration of credit chance is a key piece of the general hazard administration framework and is essential to each bank’s base and in the long run the survival of all managing an account foundation. It is in this way critical that credit choices are made by sound investigations of dangers required to maintain a strategic distance from damages to bank’s gainfulness. They held powerful management of credit risk is a primary part of a far reaching strategy to chance management and primary to the long achievement of all saving money organizations.

Sindani (2012) investigated the “Effectiveness of credit Management System on Loan Performance: Empirical Evidence from Micro-Finance Sector in Kenya “, discovered that the Credit detailed from Microfinance establishments do influence advance implementation; contribution from credit manager and officer alike and clients in defining credit conditions influences advance implementation. Funding costs

indicted negatively affected the implementation of the credits, the greater the funding costs the lower the advance execution.

Brewer (2007) perceives that loaning to small firms is tough as a result of the issues of data asymmetry. However, inventive approaches in discussing the problems have the tendency to increase credit accessibility to the organizations. The two diverse advancements in small business financing are; improved use of credit scoring innovation and the presentation of microfinance loaning organizations. In spite of the fact that these two methodologies make utilization of various advancements, they give a profitable picture of how loaning to small firms is developing after some time.

Olomola (2002) discovered that reimbursement is altogether influenced by borrower’s attributes, moneylender’s qualities and advance qualities. Reimbursement issues can be in form of credit misconduct and default. Whatever the procedure be that as it may, the borrowers alone can’t be considered mindful wherever issues emerge, it is vital to look at the degree to which the two borrowers and moneylenders consent to advance contract and also the nature and obligations, duties and commitments of the two gatherings as reflected in the outline of the credit program instead of stacking faults just on the borrows

According to prior studies as discussed earlier in this section. It was discovered that most investigation so far are especially arguing about the advance recuperation issues, determinant factors for lack of repayment by borrowers in monetary establishments is common in small-scale lending. Having likewise seen in the survey of academic writing that there is no research piloted to evaluate the effectiveness of credit management in the performance of small scale enterprises which is seen as a major catalyst of economic development.