By William Trent, CFA of Stock Market Beat

When we recently reviewed the 10K report for ITT Educational Systems (ESI), we said there were some earnings quality concerns. Among them were “Doubtful accounts – reserve nearly doubled despite a decline in total receivables.” Apparently that is an industry-wide problem, according to this article from Reuters.com:

Apollo Group Inc. (APOL) said on Monday it expected to raise its allowance for doubtful accounts and associated bad-debt costs by about $38 million as it works to complete its delayed quarterly financial report.

The for-profit education provider also said Nasdaq had granted it an extension to file its quarterly financial report.

The allowance increase follows a review of the company’s write-offs in the fiscal years 2000 to 2006 that concluded Apollo’s previous allowance for doubtful accounts was understated.

Apollo said of the $38 million, $24 million relates to years prior to 2006. Bad-debt expense would be reflected in a restatement of its results.

The allowance for doubtful accounts is not the actual bad debt expense a company incurs, but rather an estimate of it. Accounting rules require that expenses be recognized at the same time as revenues, but the bad debts will not be known until several months after the revenue is earned. The estimate, in allowance for doubtful accounts, makes the match.

If the estimate is reasonably close everything is working according to plan. Any differences due to bad debts being either higher or lower than the estimate will be adjusted on the balance sheet rather than the income statement.

However, because it is an estimate there is the potential for the estimate to not be reasonably close. This could occur due to misfortune, poor estimating skill or management attempts to manage reported earnings per share. Investors can monitor the amount charged to the allowance as a percentage of accounts receivable or sales. If the company is accruing less than normal, it will inflate their earnings in the current period.

ITT Educational is a current member of our Small Cap Watch List, and Apollo is on the Mid Cap Watch List and Large Cap Watch List.

This case is a little different. They will be adding to the allowance, which reduces the current period earnings. But since the adjustment reflects prior year results it means they were reserving too little before – and that earnings forecasts based on the company’s prior profitability levels are probably too optimistic.

For more information, see all articles on: Stock Market, ESI, APOL

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