Applying Statistical Methods to the Loss Reserve Calculation: Who Doesn't Want a 1,000% ROI on a Six-Month Project? (Selected Topic)

Article excerpt

This article addresses an opportunity in the utility industry for significant benefits, Building on the concepts put forth in "Scoring the Account Lifecycle," this article will articulate why a company should take the logical next step beyond the use of statistically based behavioral scoring for risk analysis and collection treatment strategies to the use of statistical methods for loss reserve calculation. The good news is that your organization can implement this methodology even if you're not yet using behavioral scoring. Scoring for customer treatment purposes will be an outgrowth of the reserve methodology analysis and development.

Introduction

It doesn't seem like too much of an over-generalization to put forth the following rationale for a re-evaluation of the loss reserve calculation process.

1. Regulation created an environment where utilities needed to be, and benefited from being, "conservative" in their approach to reserving for potential losses.

2. Deregulation, in all its forms, brings the end of regular rate reviews and adjustments, unless it's downward, and a focus, best described as if under a microscope, on shareholder returns, O&M (operational and maintenance) expense reductions, DSO improvements, delinquency reductions, and increased revenues from non-service sources.

3. Traditional methods for calculating loss reserves don't differentiate between accounts charging-off in January versus those in July.

4. Most current methodologies also don't consider that you cannot forecast which customers will go to final or inactive status; aging buckets alone, even if combined with Tariff or account type, are not sufficient data for an accurate reserve calculation; and the effects of external economic factors are not adequately considered.

This article will address the following:

* The purpose of the Loss Reserve.

* A brief overview of accepted methods for calculating the reserve.

* Investment in a thorough understanding of customer behavior such as through scoring, meets the requirement needed to justify developing a new loss reserve methodology.

* Of those who do "final," it can be predicted with great confidence who will or won't pay. Understanding who won't pay and will charge-off can be applied to the entire A/R in order to calculate a more accurate reserve.

* How economic factors are accounted for in a good statistical model

* External auditor approval.

Loss Reserve: What Is It?

Even if you aren't personally responsible for the care and feeding of the loss reserve estimate, if you are involved in credit, collections, customer service, sales or finance, you are likely affected by it daily.

At its simplest, the loss reserve is an estimate of that portion of the outstanding accounts receivable that will most likely not be collected. In a cash accounting environment, reserves are not technically an issue because income isn't recognized until payment is received. Before creation of the reserve concept, charge-offs were booked as an adjustment to income when they were deemed uncollectible. The problem with this approach is that losses, if not accounted for until deemed uncollectible, are not recognized in the same period as the corresponding income. So the "Reserve" or "Allowance for Bad Debt" concept, a multiple entry system for estimating future losses and accounting for it against the appropriate revenue, was developed. Without going into the gory details of the debits and credits necessary, the gist of the process is that a contra asset account, Allowance for Loss Reserve, is set up with the A/R on the balance sheet. The estimated losses for the present A/R are booked to this account in order to reflect the true net value of the A/R. This valuation is critical for accurate reporting, budgeting and investor analysis.

Borrowing from SEC banking regulations regarding loss allowance calculations, since there aren't regulations and processes documented specifically for utilities, or most other industries, here are some nuggets of wisdom regarding loss reserves. …