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Analysis of Bad Debts

Difficulty: Advanced

Allowance for doubtful accounts receivable (bad debts) is a contra account which reduce the balance of the company's gross accounts receivable.The relationship between the allowance and the balance in receivables should be relatively constant unless there is a change in the economy overall or a change in customer base.


Receivables Accounting Policy

Allowance for Doubtful Accounts

The allowance for doubtful accounts is based on Cisco's assessment of the collectibility of customer accounts. Cisco regularly reviews the allowance by considering factors such as historical experience, credit quality, age of the accounts receivable balances, economic conditions that may affect a customer's ability to pay, and expected default frequency rates. Trade receivables are written off at the point when they are considered uncollectible.

Financing Receivables and Guarantees

Cisco provides financing arrangements, including leases, financed service contracts, and loans, for certain qualified end-user customers to build, maintain, and upgrade their networks. Lease receivables primarily represent sales-type and direct-financing leases. Leases have on average a four-year term and are usually collateralized by a security interest in the underlying assets. Loan receivables include customers financing purchases of Cisco's hardware, software and services and also may include additional funds for other costs associated with network installation and integration of Cisco's products and services. Loan receivables generally have terms of up to three years. Financed service contracts typically have terms of one to three years and primarily relate to technical support services.

Cisco determines the adequacy of its allowance for credit loss by assessing the risks and losses inherent in its financing receivables by portfolio segment. The portfolio segment is based on the types of financing offered by Cisco to its customers: lease receivables, loan receivables, and financed service contracts.

Cisco assesses the allowance for credit loss related to financing receivables on either an individual or a collective basis. Cisco considers various factors in evaluating lease and loan receivables and the earned portion of financed service contracts for possible impairment on an individual basis. These factors include Cisco's historical experience, credit quality and age of the receivable balances, and economic conditions that may affect a customer's ability to pay. When the evaluation indicates that it is probable that all amounts due pursuant to the contractual terms of the financing agreement, including scheduled interest payments, are unable to be collected, the financing receivable is considered impaired. All such outstanding amounts, including any accrued interest, are assessed and fully reserved at the customer level. Cisco's internal credit risk ratings are categorized as 1 through 10, with the lowest credit risk rating representing the highest quality financing receivables. Typically, Cisco also considers financing receivables with a risk rating of 8 or higher to be impaired and will include them in the individual assessment for allowance. Cisco evaluates the remainder of its financing receivables portfolio for impairment on a collective basis and records an allowance for credit loss at the portfolio segment level. When evaluating the financing receivables on a collective basis, Cisco uses historical default rates and expected default frequency rates published by major third-party credit-rating agencies as well as its own historical loss rate in the event of default, while also systematically giving effect to economic conditions, concentration of risk, and correlation.

Expected default frequency rates and historical default rates are published quarterly by major third-party credit-rating agencies, and the internal credit risk rating is derived by taking into consideration various customer-specific factors and macroeconomic conditions. These factors, which include the strength of the customer's business and financial performance, the quality of the customer's banking relationships, Cisco's specific historical experience with the customer, the performance and outlook of the customer's industry, the customer's legal and regulatory environment, the potential sovereign risk of the geographic locations in which the customer is operating, and independent third-party evaluations, are updated regularly or when facts and circumstances indicate that an update is deemed necessary.

Financing receivables are written off at the point when they are considered uncollectible, and all outstanding balances, including any previously earned but uncollected interest income, will be reversed and charged against the allowance for credit loss. Cisco does not typically have any partially written-off financing receivables.

Outstanding financing receivables that are aged 31 days or more from the contractual payment date are considered past due. Cisco does not accrue interest on financing receivables that are considered impaired or more than 90 days past due unless either the receivable has not been collected due to administrative reasons or the receivable is well secured and in the process of collection. Financing receivables may be placed on nonaccrual status earlier if, in management's opinion, a timely collection of the full principal and interest becomes uncertain. After a financing receivable has been categorized as nonaccrual, interest will be recognized when cash is received. A financing receivable may be returned to accrual status after all of the customer's delinquent balances of principal and interest have been settled, and the customer remains current for an appropriate period.

Cisco facilitates arrangements for third-party financing extended to channel partners, consisting of revolving short-term financing, generally with payment terms ranging from 60 to 90 days. In certain instances, these financing arrangements result in a transfer of Cisco's receivables to the third party. The receivables are derecognized upon transfer, as these transfers qualify as true sales, and Cisco receives a payment for the receivables from the third party based on Cisco's standard payment terms. These financing arrangements facilitate the working capital requirements of the channel partners, and, in some cases, Cisco guarantees a portion of these arrangements. Cisco also provides financing guarantees for third-party financing arrangements extended to end-user customers related to leases and loans, which typically have terms of up to three years. Cisco could be called upon to make payments under these guarantees in the event of nonpayment by the channel partners or end-user customers. Deferred revenue relating to these financing arrangements is recorded in accordance with revenue recognition policies or for the fair value of the financing guarantees.

Source: Cisco Systems Inc., Annual Report

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Allowance for Doubtful Accounts Receivable

 
Jul 29, 2017 Jul 30, 2016 Jul 25, 2015 Jul 26, 2014 Jul 27, 2013 Jul 28, 2012
Selected Financial Data (USD $ in millions)
Allowance for doubtful accounts
Accounts receivable, gross
Ratio
Allowance as a percentage of accounts receivable, gross1 % % % % % %

Source: Based on data from Cisco Systems Inc. Annual Reports

2017 Calculations

1 Allowance as a percentage of accounts receivable, gross = 100 × Allowance for doubtful accounts ÷ Accounts receivable, gross
= 100 × ÷ = %

Ratio Description The company
Allowance as a percentage of accounts receivable, gross Allowance for doubtful accounts divided by the gross accounts receivable. Cisco Systems Inc.'s allowance as a percentage of accounts receivable, gross declined from 2015 to 2016 and from 2016 to 2017.

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Allowance for Credit Losses

 
Jul 29, 2017 Jul 30, 2016 Jul 25, 2015 Jul 26, 2014 Jul 27, 2013 Jul 28, 2012
Selected Financial Data (USD $ in millions)
Allowance for credit loss
Gross financing receivables less unearned income
Ratio
Allowance as a percentage of gross financing receivables less unearned income1 % % % % % %

Source: Based on data from Cisco Systems Inc. Annual Reports

2017 Calculations

1 Allowance as a percentage of gross financing receivables less unearned income = 100 × Allowance for credit loss ÷ Gross financing receivables less unearned income
= 100 × ÷ = %

Ratio Description The company
Allowance as a percentage of gross financing receivables less unearned income Allowance for credit losses divided by the gross financing receivable. Cisco Systems Inc.'s allowance as a percentage of gross financing receivables less unearned income declined from 2015 to 2016 and from 2016 to 2017.

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