subject: Net Realizable Value of Assets [print this page] Net Realizable Value of Assets Net Realizable Value of Assets
Every business firm that sells its products or services on credit knows that some customers will not pay. Likewise, financial institutions that loan money must expect that, despite their best efforts to the contrary, some borrowers will fail to pay their debt obligation. Obviously a financial institution does not know exactly which borrowers will not pay. (If they did know which borrowers would not pay, then they would not loan money to those borrowers in the first place.) However, an institution does know from experience and current economic conditions that a certain percentage of loans will not be repaid. But how does a financial institution account for these bad debts? Generally Accepted Accounting Principles (GAAP) require a firm to establish and maintain adequate allowances for loan losses and to record assets, such as accounts receivable or mortgages receivable, at their fair value. Under GAAP, the fair value of an asset is the amount at which that asset could be bought or sold in a current transaction between willing parties, other than in a liquidation. So it follows that if the firm knows that a percentage of loans will not be repaid and receivables will not be collected, then it should somehow reflect that fact in its financial statements. Firms accomplish this by reporting the net realizable value of their receivables accounts. That is, the amount of the receivable account that the firm realistically expects to be received.
When a firm estimates the amount of a receivable account that is unlikely to be collected, it makes a valuation adjustment to reduce the carrying value of the asset and recognize the bad debt expense. For example, if Bank Alpha's mortgages receivable account has a balance of $1 billion and it estimates that 3 percent of the account balance will not be collected, it must somehow reduce the value of the mortgages receivable asset by $30 million in order to reflect its fair value. To do this, the bank will credit its loan loss reserve account and debit its bad debt expense (or loan loss provision). The loan loss reserve is a contra asset account that serves to devalue the receivable asset and arrive at the asset's net realizable value (carrying value). It is a valuation account whose credit balance is subtracted from the debit balance of the mortgages receivable account. The bad debt expense or loan loss provision is an expense item that adds to the loan loss reserve. The expense account is used to maintain the appropriate level of loan loss reserves as determined by management. The ledger entry would appear as follows:
Dr. Bad Debts Expense.....................$30,000,000
Cr. Loan Loss Reserve.................................................$30,000,0000
The balance sheet presentation for our example would appear (in thousands) as:
Mortgages receivable $1,000,000
Less: Loan loss reserve (30,000)
Net mortgages receivable $ 970,000
So what happens when Bank Alpha determines that a specific borrower cannot or will not pay his debt obligation? As a specific account is determined to be uncollectible, it is "written off" against the allowance account that the bank maintains for just this purpose. Following our example from above, if the firm determines that the Jones' account is uncollectible, it will credit the mortgages receivable account and debit the loan loss reserve account. (Remember that the loan loss reserve is a contra asset, so a debit reduces the value of the asset.) If the Jones' account balance was $500,000, the ledger entry would appear as follows:
Dr. Loan Loss Reserve...........................$500,000
You should take note that while the write-off did decrease the gross value of the mortgages receivable asset, it had no effect on the net realizable value of the asset. The write-off entry removed from the mortgages receivable account an amount for which management had previously made provisions. The balance sheet presentation would be:
Mortgages receivable $ 999,500
Less: Loan loss reserve (29,500)
Net mortgages receivable $ 970,000
Therefore, by recognizing and providing for bad debts, management is able to report a more accurate value of receivable assets. This provides the financial data user with a more useful and truthful picture of the firm's financial situation and allows for more realistic measures of return on investment, return on equity, and liquidity.
However, investors should keep in mind that the management of a firm has a significant amount of discretion in estimating loan loss provisions and determining fair value. Management and accounting personnel may well be under the influence of the conflicting interests to make adequate provisions for loan losses yet not understate earnings, for example. Recent developments in the economy and banking industry have underlined the fact that loan loss provisions and fair values are not always estimated accurately. Perhaps if better accounting rules and regulations existed the recent financial crisis could have been lessened or possibly averted entirely.
