[The downside to being a full-time attorney and part-time blogger is the periods when case loads increase and trials commence. Now that we're back to the usual level of insanity at Barker Martin, P.S., we'll do our best to keep this blog updated more frequently. Thank you for your understanding and continued readership.]

In advance of the upcoming community association budget season, I posted on one of the Linked-In groups to which I subscribe a query on whether associations utilize a bad debt line item in their annual budgets. Numerous industry experts, from managers to CPAs, provided insightful and valuable responses, some of which I'd like to share here. 

The respondents universally agreed that in today's turbulent economic climate, a condominium or homeowner association should include a bad debt line item in their annual budget.  Mitch Drimmer pointed out that before an association can put in a number for bad debt, "bad debt" must be defined. "There is debt that is absolutely collectible and there is debt that is possibly collectible and then there is stone cold bad debt. How do you define and how do you calculate it?"

CPA Heather Clark responded to Mitch's question by stating the following:

There are two aspects of bad debt from an accounting perspective. There is the allowance for doubtful accounts and there is bad debt expense which is the charge that adjusts the allowance for doubtful accounts:

1. What is an allowance for doubtful accounts?
a. An allowance for doubtful accounts is an estimate of the amount in your receivables that will not be collected.
b. The receivable account is an asset account and the allowance for doubtful accounts is a contra asset account i.e. an account that reduces the balance of the receivable account. So if the receivable balance is $100,000 and the allowance is $25,000 the net receivables on the books is $75,000.

2. What is bad debt expense?
a. Bad debt expense is the expense charge for increasing the allowance account which reduces net income (revenues less expenses).
b. So using the example above, if at December 31, 2009 the allowance for doubtful accounts is $100,000 and it is determined that at July 31, 2010 the allowance needs to be $130,000, then assuming no other adjustment to the allowance in the year 2010, the bad debt expense to be booked in July would be $30,000 (increase to $130,000 from $100,000).

Heather continued:

Having an allowance for doubtful accounts does not mean all the accounts reserved for are uncollectible. Some may be fully collectible while others are partially collectible and others may not be collectible at all. Determining the amount needed in an allowance for doubtful account is an estimate which requires judgment. It is important determining the adequacy of the allowance for doubtful accounts that collection practices and legal action being taken be considered. If no legal action is taken accounts that are collectible may become uncollectible while legal action may result in accounts being wholly or partially collectible.

Ryan Coburn responded to Heather's comments with the following:

We use the method outlined by Heather. On a quarterly basis I review the outstanding accounts with a focus on the 120+ days outstanding which gives me a good idea of what is in collections and at risk of being not collectible. We have consistently been able to collect all but 20% of the 120+ days outstanding so that amount plus the amounts outstanding for properties in foreclosure is what we show on the balance sheet as an offset to our receivables (Allowance for Doubtful Accounts). We have only had to increase this contra asset account in small amounts so there has not been a material impact on our P&L. We do not budget for the expense because we are in a good position on our balance sheet and any bad debt expense is more than offset by other income.

Association manager Lori Burger summarized the initial discussion:

Basically, we're making an informed decision to enter into the budget an amount for the exposure the HOA may face because of a foreclosure. Management companies have good statistical data on how the community, as well as local communities, is being affected by foreclosures. By having added a conservative amount into the budget and a unit actually does foreclose, hopefully the HOA would not have to ask the members for a special assessment to cover the cost of the uncollected assessments. On the other hand, if there was no foreclosure during the year, then the Board could use these funds built into the budget to offset the next year's assessments. For example, if you built in $20K into the budget for potential losses due to foreclosures and you had no need, you should have the $20K to use to offset (or lower) the annual dues the following year by $20K. This of course varies from state to state.

Now that we've defined and discussed bad debt, in Part 2 of this blog post, I'll cover the difference between cash and accrual accounting related to bad debt budgeting.  Stay tuned in a few days for the follow-on post.