China Finance: As unpaid bills mount, bad debt allowance is key

As China's economic growth slows, many companies are feeling the squeeze. Profits are falling, and businesses are reportedly having a lot of issues collecting on debt. This last point is of some concern for me, as I’ve seen some companies lowering their allowances for bad debt.

Inadequate debt allowances are an issue that will really come to play at some later date, but it’s an important point to check for any type of technical analysis of a company. It can also be a first sign in a pattern of more aggressive accounting policies to try to hide the slowdown in a business.

Amid reports that Chinese companies are increasing having trouble getting clients to pay their bills, it means that corporate accounting numbers may be taking an even greater flight from reality. 

Here's an example of what to look for in a company's financial statements, using Great Wall Motor's (HKSE: 2333) latest annual financial statements from the Hong Kong Stock Exchange. We see an increase in accounts receivables, which is to be expected during the current economic climate, and something to be expected with an expanding business. But we also see that although current accounts receivables have doubled, allowance for bad debt has actually decreased.

We also see a big disconnect when we have a look at how provisions for bad debt is calculated for aging receivables, where we would expect to see a curve going up with the age of the receivable. We do indeed see this for 2010, but the change in policy becomes very clear in this table. The allowance for the 1-2 year time frame goes from 33% to 0%. It appears to have been strategically changed in order to help achieve maximum impact as the other time frames still have some allowances.

These allowances for bad debt are lower across the board, however, as we see a very blatant change towards more aggressive accounting policies.

Completely cancelling all bad debt allowances for the vast majority of your aging invoices in just one year is something of an extreme step to take, and should raise a few eyebrows. But what’s really concerning here is that what we’re hearing from China is that given the current business conditions, these allowances should be increasing, if anything.

And if the company's clients are not - as in Great Wall Motors' case - smaller firms, but big companies that account for a majority of a company’s sales, these types of trends should be taken even more seriously.  Financial troubles at one big client could have a major impact on whomever is holding its receivables.

Bad debt allowances are easy to find and compare across a few years, which means it’s a very good place to start digging. While by no means being a guarantee of fraud or overly aggressive accounting, they are still a red flag, and should be cause for further examination.