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Accounting of account receivables (AR).
Abstract:
In governance of business administration quality of financial statements is a critical issue. After bitter experiences with practices of off-balance sheet accounting, the concept of Accounts Receivable (AR) has increasingly gained managerial attention. One reason for this attention is that AR can be used, in highly flexible ways, to influence the bottom lines and debt/equity ratios.

The purpose of this study is that by means of the imperative of disclosure and a number of other accounting principles and ideas such as objectivity, materiality, matching, and fair value to critically analyze the techniques used in the valuation and measurement of AR.

Keywords: Accounting recognition, Account receivables, accounting disclosure.

Article Type:
Report
Subject:
Valuation (Usage)
Accounts receivable (Usage)
Accounting (Technique)
Accounting (Usage)
Author:
Pashang, Hossein
Pub Date:
03/01/2010
Publication:
Name: Review of Business Research Publisher: International Academy of Business and Economics Audience: Academic Format: Magazine/Journal Subject: Business, international Copyright: COPYRIGHT 2010 International Academy of Business and Economics ISSN: 1546-2609
Issue:
Date: March, 2010 Source Volume: 10 Source Issue: 2
Topic:
Event Code: 200 Management dynamics Computer Subject: Company business management
Accession Number:
237533637
Full Text:
1. INTRODUCTION

The notion of account manipulation, which encompasses "earnings management", is mainly attached to the items of income statements. For example, Copeland (1968) focused on income statements and observed that management influence the size of net income purposefully. By constructing the three concepts of "income minimizers", "income maximizers" and "income smoothers" he put earnings management at the centre of research focus. Notably, the concept of earnings management denotes a particular type of accounting practices that draw the attention only on the income statements. However, accounts manipulation may have classificatory practices, those related to the balance sheets and income statements classifications. These types of manipulations are not described in the literature. Perhaps, a reason for this shortcoming should be related to the complexity of the accounting techniques that are applied to promote earnings management.

A study carried out by Richardson et al. (2002) showed that earnings management are chiefly based on revenue recognition that includes AR. He did not show that in which way AR are used to manipulate the accounts. Observations of the accounting irregularity and accounting errors make authorities to ask for restatements or correction of the annual reports. The reason for AR-related restatements should be related to the desired "earnings management" that encompasses manipulations of both balance sheets and income statements.

It seems like that "earnings management" is on the way to be replaced by the concept of "managed accounts". This new concept reconstructs the old concept of earning management and communicates a more neutral and fashionable view of management influences in accounting (see, e.g., Financial Times June 8, year 2009). By definition, earnings management communicates a set of ways in which management artificially manages to meet some pre-established level of expected earnings, e.g., the analysts' forecasts. By keeping pace with some earnings trend, estimated by analysts, it is a priori assumed that the investors' perceptions of risk can be affected (Riahi-Belkaoui 2005; Mathews and Perera 1996). Essentially, this type of accounts manipulation is based on a common functional fixation view of share price determination in the sense that accounting numbers determine share prices (Mathews and Perera 1996). In any case, earnings management denote practices that may affect income statements and items such as cash flow, net income, or risks perceived by analysts.

On the one side, the term "managed accounts" was invented to indicate transparency in practices of return strategies such as hedge fund management. Institutional investors have asked disclosures about those accounts that "managed" by management to increase the return. Hedge accounting is one account by which managers attempt to increase the net income. In this sense, the meaning attributions of "managed accounts" are in contrast with the meaning attributions of "earnings management". On the other side, the term "managed accounts" indicates a full spectrum of accounting related service platforms to improve profitability of the firms. This means that management tend to use this concept as a touted panacea to repair the bad reputation attached to the term "earnings management". Management can present some service platforms, such as hedging or to increase the net sale by credits in order to show higher profitability. As we see, the concept of managed accounts is confusing. This study focuses on the technical aspects of AR in order to show how AR can be "managed". A report issued by the United State General Accounting Office (GAO) shows that almost 38% of "accounting irregularities"- which required restatement--were related to the improper recognition of revenues based on AR.

According to GAO, the major reasons of restatements between 1977 and 2002 (sample periods) are:

AR is one of the key accounting tools that has increasingly used as a service platform, e.g., to enhance profitability and at the same time, construct a favourable image of risk. AR is used both for the purposes of "earnings management" and restructuring of balance sheets to portrait the financial positions less risky.

The accounting techniques and procedures that can be used for the reporting of AR are not presented and analyzed by researchers. This study applies an inductive method in order to show how the growth of AR has motivated innovation of a set of methods to account for AR. It illustrates the estimates applied for the valuation of AR and by this it contributes to the understanding of a new form of desired accounting treatment.

2. MANAGEMENT OF AR IN A THEORETICAL LIGHT

According to Paton (1922) accounting should be changed continuously in order to keep pace with the entities economic growth and changes. One of the key factors underlying the recent concept of economic growth is the development of management policy for credit sale. Credit sale is now a management service platform by which profitability can be increased. However, an increase in credit sale may create space for influencing a favourable classification in the balance sheets. From the standpoint of accounting the economic growth by credit is paradoxical; that is, an increase in credit sale creates a set of balance sheet-related problems, particularly for the application of principles such as prudence, materiality and objectivity. Thus, management policy of credit sale impacts the process of accounting for AR and as a consequence the operational value of AR becomes ambiguous. An increase in the credit sale enlarges the material size of AR, increase the size of the inventory, and (assumingly) the cash-flow. Beside these changes, the distributions of value between the categories of current and non-current assets will be affected. For example, an increase in AR causes a decrease in cash, and a need to increase inventory which is, in return, related to the proportional increase in sale. We can stress that a change in AR causes a chain of effects on the categories of assets at the balance sheet and rules of valuation and estimates.

In spite of these balance sheet-related influences, the key influence factor should be related to the impact of AR on income statement. By means of AR revenue will be increased. Beside this, the gap between realizable revenue and sale will be increased. We may say that the simple concept of "economic growth" by credit turns to become a "nightmare" for accountants and accounting of growth in a reliable way.

When management importance of AR has increased, standard setters became curious about the scope of uncertainty that surrounds AR. The trend toward credit sale increased the risk of credit losses. When accountants will eliminate the risk, they should make a reference to the principles of prudence (conservatism), objectivity (and materiality), substance over form, and matching. An emphasis on prudence means to resolve the problem of overstating of value. The concept of prudence suggests that the value of AR should be reduced to an adequate level. On the other side, the principle of objectivity suggests that accounting of AR should be based on the "realizable value". This further suggests that book-value needs to be reduced to reach a realistic level. And finally, the concept of matching principle suggests that any reduction in the value of asset, here AR, should be expensed in regards with the year in which this reduction arises. This latter idea is directly associated with the diverse meaning attributions that we normally attach to the principle of "substance over form". Here it is meant that, uncollectable accounts (bad debts) should not affect the expenses (and hence the profit) of the year in which they legally proved to be uncollectable (or bad). Instead, the bad debts should be matched as an expense in the year they arise. Paradoxically, too much emphasis on matching (a means to reach fair value and also a means to reach substance over form) provides a space for managerial interpretations and ad hoc accounting. For variety of reasons, firms move towards matching and fair value accounting of AR because it is required by IASB (International Accounting Standards Board). The analysis of the underlying factors that affect accounting of AR attests to the shift in the application of AR by small and big firms. Firms of varied size attempt to apply AR as a managerial service platform, for example, in dealing with customers or to improve the operational and financial performances, market share, growth and profitability (Needls et al., 1996). These management choices or platforms provide spaces for the firms to adopt a set of flexible techniques in accounting of AR. It is not surprising that Lin et al. (2003) expressed their concerns about assessing the risk of fraudulent financial reporting.

In the following sections the major focus is directed on the standards and the related techniques used for the accounting of AR. The aim is to show how the options of different techniques and arbitrary nature of the accounting estimates can influence accounting classifications.

3. AR AND PROBLEM OF CLASSIFICATION

In modern accounting to make lines of division between tangible and intangible items is of special importance. One major problem is that standard setters cannot always follow the logic of the accounting theories (Puxy1993). Classification of AR has some meaning for valuation of AR. A question that we can be addressed is that is AR a tangible or intangible asset?

According to Paton (1922), "The most logical view is to consider as intangibles all immaterial properties, such as patent, leaseholds, goodwill, trade-marks, copyrights, royalty rights, etc., and all other rights or claims, such as securities and open customer accounts. Accounts receivable are certainly as fully immaterial in nature as patent rights (p. 213)".

It is reasonable to assume that AR are not a cash or cash equivalents, rather they are rights to cash a kind of legal right. Arguably, legal rights should be classified as intangible assets. Clark (1930) is perhaps the first writers who focused on AR from the customer credit point of view. He emphasized that AR is an intangible asset that is structured by involvement of management.

In spite of this early theoretical recommendation, the work of classifying AR in terms of tangible/intangible asset is not fully completed. An immaterial asset like accounts receivable which is classified as none-intangible is not theoretically sound. It seems like that IASB wishes to treat as intangibles only those assets that have somewhat dubious nature. As mentioned by Paton, by creation of a separate classification for AR, the intangibles are portraits as dubious and non-important items in the (ownership) traditional accounting. It is paradoxical that the test of tangibility is not related to the immaterial nature of an asset. This means that classification is not being used to designate the nonphysical or immaterial assets as a group. In the following sections, we consider AR as an intangible asset that lacks physical substance. It is classified as entity's "right" to future customer payments. Further, it is assumed that the book-value of this asset is not the same as its realizable value. As the volume of this assets increases, it is materially reasonable that realizable value to be estimated.

3.1 International Standards for Accounting of AR

The Swedish accounting lacks sufficient standards aimed at estimating the realizable value of the AR. Thus, we need to refer to IAS (International Accounting Standards) standards. Concepts and rules for recognition and accounting treatment of AR are initially developed in IAS 1. In order to prevent misleading, cash that is not available for immediate use (e.g. AR) should be disclosed separately. In the revised IAS 1 (effective 2005), cash which restricted and not available for use within one year of the balance sheet date should be included in non-current assets. Considering this rule, AR can be defined both as a current and non-current asset. A portion of AR can take more than one year to be converted into the cash and thus cannot be classified as a current asset. This problem is not solved by IAS.

IAS 7 brings forward the concept of cash equivalent. By definition, cash equivalent is short-term (limit of three month) and risky investment. There is also a possibility that the concept of cash equivalent be applied in order to create a separate caption for AR. AR is a risky concept and view of "service platform" makes this concept to be more risky than ever. The interpretation is that the concept of cash equivalent may confuse the classification one step further. That is to say that, it is possible that AR to be classified as the categories of current, non-current and cash-equivalent.

For some companies that sell to consumers, instalment accounts receivable, note receivables and trade receivables constitute a significant portion of AR (see appendix 1).

Although instalment accounts receivable allow the customers to use a payment periods which may be 24 months or more, they are (often) classified as current assets. If instalment policy is customary in an industry, the instalment accounts receivable should be classified as current accounts in the balance sheet and be treated as AR.

Another technical problem is how to delimit caption of AR as an object of classification. As the volume of AR increases the riskiness increases and this change in risk should affect the goal of classification. For example as the grade of riskiness increases, it is reasonable that the principle of prudence to be more emphasized. An emphasis on prudence requires precision in estimates and a change in recognition procedures. How AR should be defined? Receivables include trade receivable, note receivables, trade acceptances, third-party instruments (for example loan to employees, affiliated companies etc.) and interests receivable. Sometimes acquisitions and sales of subsidiaries cause charges--movement charges- which are related to the basis of customers. Practically, accountants insist on the various classes as a separate and distinguishable post. Considering this, IAS provides no guides for the classification of AR.

IAS 39 and IAS 18 provide some guide lines for the reporting structure of AR. IAS 39 addresses recognition, de-recognition and measurement of receivables as if it is a financial asset. In the revised version of IAS 39 and IAS 32 (which treats financial instruments) a commitment to a strict "substance over form" approach is recommended. This requires, in return, a focus on good matching and fair value accounting for the treatment of AR.

It should be argued that in regards with the determinant of "substance over form" or fair value accounting, practitioners have developed a range of procedures for the recognition, valuation, measurement, and reporting of the uncollectable receivables. None of these practical techniques are included in IAS guide-lines. In the following sections these technical approaches will be presented.

3.2 Accounting Valuation of AR

In the previous section, it was argued that standard setters have a difficulty to classify AR. The classification problem has its root in recognition and measurement of AR. Basically, the accounting treatment of AR is not similar to those applied for the accounting of current and noncurrent assets. Instead, it is more similar with recognition rules used for the accounting of intangible assets. The reason for this should be related to the notion of "contra accounts" and the need of particular procedure for evaluation of risks. Notably, the book-value of accounts receivable is often under the "recovering value" because of the following economic situations:

1. It is difficult to assess the creditworthiness of the customer, particularly in periods of economic recession.

2. The customer may refuse to accept the price charged. As the volume of credit sale increases, the probability for the refuse of products will be increased.

3. The customer may refuse to accept some of the products because they were faulty.

In current accounting, AR is categorized as current assets, usually converting into cash within 30 to 60 days. Therefore, AR appears in the balance sheet immediately after cash and short term investment in marketing securities. This type of classification creates problem for calculation of cash-flow.

There are many reasons indicating that the book value (carrying amount) of the AR is higher than its recovering amount (net realizable value), and as such, the AR should be impaired. The accounting adjustment of AR is the most commonly occurring accounting issues and problems that accountants need to deal with. The principles of prudence, fair value, objectivity, and matching are key concepts that accountants apply to recognize, measure, and valuate the AR. The relationships between these principles and measurement are promulgated in IAS in the following way.

"When an uncertainty arises about the collectability of an amount already included in revenue, the uncollectible amount, or the amount in respect of which recovery has ceased to be probable, is recognized as an expense, rather than an adjustment of the amount of revenue originally recognized" (IAS 18, IASC 1993: [section] 22).

This standard implicates the requirements of the two key accounting procedures, (1) uncollectible amount should be valued objectively, (2) and be expensed as they arise. This standard ensures that the bad debts do not affect the expenses of the year in which they prove to be bad (legally approved), but rather the year in which the credit transaction is taken place. The position of IAS 18 is accounting by "substance" rather than by "form".

If loans or sales are not made for the regular costumers, and made to employees, officers of corporation, or owners they should be shown separately. Such a separation is not specified in IAS, meaning that standard setters neglected to provide guidelines for an important classification. A further technical notion worth mentioning is that accounts receivable have debit balance. Sometimes customers overpay their accounts e.g. by mistake or in anticipation of future purchase. The overpaid accounts should be classified as a current liability.

In sum, the problems attached to the accounting of AR are many. Some of these problems concern management- how to increase, control and account the cash-flow and receivables or to delimit the risk of uncollectability; other problems should be related to the notion of reporting or task of accountants in regards with matching principles, materiality and reliance.

3.3 Accounting Models for Reporting of AR

Accounts cannot wait for standard setters. Like any other practitioners they develop their techniques and they expect that these technique to be "legitimized" by standard setters and law makers. In recent years two types of methods has been developed to deal with the problem of accounting of AR. These methods are not clearly defined in the current textbooks.

Broadly speaking, there are four techniques for the recognition and measurement of AR. These four techniques shape two distinctive methods. We name here one of them as an individual method of treatment and the other one as a collective method of treatment. Disregarding the size of the companies, if the numbers of credit sale are limited, an individual methods, and if the numbers of credit sale is high the collective methods are applied. For example, a car dealer firm that sells less than 100 cars per year uses an individual method; while a dentists that serve more than 1 000 patients per year needs to use a collective method. When the prices of goods/services are materially high, risk of the credit should be treated individually. On the contrary, when the number of the items sold is high and prices are materially low a collective treatment is advisable. Individual methods are based on judgement and collective methods on estimates. In the following sections both methods will be presented.

3.3.1 Individual Methods

The individual treatments have two frameworks, a legal and an economic. In both methods the economic situations of the credit accounts should be judged. In the legal form a direct writ-off method is used. This means that allowance is not allowed and AR is reduced (or uncollectable customers are removed from the accounting) when the legal authorities have determined that a customer is insolvent. It takes more than several months or sometimes several years that the legal authorities to determine the insolvency of an individual customer. The use of legal guide lines puts the matching principle out of work. This means that the fair value accounting is not possible.

The economic model allows allowance meaning that on the basis of risk evaluation, a portion of the amount of AR can be adjusted per year. The final adjustment and reduction has been down when the authority has confirmed that customer is insolvent. The legal method is more reliable but less relevant; while the economic method is more relevant or is more close to fair value accounting, but less reliable. The economic model allows ad hoc accounting of the type "earnings management". Here a practical model for risk evaluation is presented. The idea is to describe how accountants can deviate from the correct procedures without being revealed by auditors or individuals who are located "outside" of accounting.

A practical approach to the risk evaluation of AR on the individual basis begins with the interpretation of the economic situations that underlies AR. The following table (2) illustrates the nature of AR and its relationships with legal and economic models of treatments.

The nature of AR can be djuged in considerations of four situations: ordinary, doubtful, disputed and unocallectible. A reliable accounting needs thre types of documents that describe the risk situations. IAS did not develop procedural rules for the identifications of the risk situations. A practical way of making distinctions between different risk situations and account for these situations is to use different "documents". The use of documents helps accountants to arrive closer to the principle of "objectivity".

In ordinary situation, it is judged that collection is certain, and there will be no foreseeable loss when collecting AR. This means that there are no evidences that indicate the failure of collections. Here, the portion of receivables that is qualified for the ordinary situation can be equated as realizable cash.

In interpreting the doubtful situation a legal document is not available. It is sufficient that accountants have some information about the payment inability of the debtor. In the doubtful situations documentation should contain two criteria; (1) claim is accepted by an uncontested customer; (2) the economic situation of the customer (debtor) is considered. For example, accountant by means of telephone or e-mail ask a customer about the time and portion of the debts that the customer can pay. Customer's answer is a ground for "documentation". The legal model of accounting refuses to accept adjustments. The economic model allows that the balance of AR to be reduced by estimated per cent of uncollectabilities. The net income can be reduced by the same estimate.

In disputed situations, claim is contested by customer and there is uncertainty considering the amount and probability of the uncollectibility. In this situation, a document--not necessarily a legal one--is involved. Customer sends a message (telephone or e-mail) in which price, quality, quantity etc. are questioned. In disputed situations, the provision of documents is initiated by customers rather than accountants. Accounting of doubtful and disputed situations is normally similar.

In uncollectible situations, claims are not collectible, debtor is insolvent and a legal document should support an uncollectible situation. At this stage, accounts should be both adjusted and reduced, that is, the customers should be eliminated from the bookkeeping accounts. A deviance from the above specified accounting procedures will lead to a type of ad hoc accounting that favour interest of individuals involved in accounting communication.

3.3.2 Evaluations by Collective Method

An evaluation credit risk by collective methods is carried out when the volume of credits is material and numbers of credit sales are high. Here, evaluation should be calculated by means of an estimate rather than judgement of situation. There are two methods by which the risk of AR can be estimated. These methods are "global estimation" and "aging of accounts".

The global estimation is even called percentage of net sale method; the aging method is even called percentage of gross receivable method.

Theoretically, the global estimation is considered as income statement and aging method as balance sheet approaches to AR. The reason for such as a theoretical distinction has a deep historical background that the description of which is out of the scope of this study.

A distinctive characteristic of the global method is that the historical data from the income statements of the previous years should be used for calculation of the estimate. In a simple way, the following table shows how estimate is calculated.

The table shows that a-three-years net sales results in 2 percent bad depth in average per year. This 2 percent can be used as an estimate for the assessment of the bad depth of the current annual revenues (or sales).

By means of aging method, AR of a company can be analyzed by consideration of past due and clusters of customers. As it is shown in the following table, based on the previous experiences, a company may use 1% rate for "not yet due" 2% for 1-30. ... etc.

The function of aging method is different compared with global method. For example, the global method helps estimating the bad depth, whereas the aging method helps estimating the target balance of allowance in order to adjust the amount of AR. We may say that aging method is good for estimating the realizable amount of AR. On the other side, the global method is good for the estimation of bad depth. When the economic situations behind the historical data of a firm keep pace with the current economic situation the differences between the two methods are not so dramatic. But, if the economic situations are changed, e.g., credit sales are increased, the use of estimate that is based on the old data is misleading. In the situation of change the aging method is preferable.

The aging method is often supported by a data program. Computer-based registering of customers provides a possibility for the treatment of uncollectible accounts in regards with the receivables past due (outstanding times). It means that the aging technique can aid cash-management, budgeting, and customer analysis. Accounting of bad depth and realizable value of AR requires a complicated procedure which is not shown here.

4. ANALYSIS AND CONCLUSIONS

By means of an inductive approach, the study could present four different valuation procedures for the accounting of AR. First a distinction made between the individual and collective treatment of AR. It was suggested that when the number of credits are increased firms account by collective methods. On the other side, when the number of customer are limited the individual methods are applied.

The study developed the key procedures needed for judging the four different economic situations that indicate the riskiness of AR. By means of a model these economic situations are related to a framework of accounting objectivity. It was showed that when a legal method for the recognition of bad depth is used practices of earnings management cannot easily be accomplished. In contrast to this, when economic situations were used as criteria of recognition, fair value accounting is allowed, and at the same time, a space for earnings management was created. That is to say that in order to match the estimated bad depths in the years they arise, management can influence the volume of estimate by interpreting doubtful situations in a desired way.

Further, the study could show two different methods of collective treatments that firms apply in situations where the numbers of credits have increased. Illustrations 3 and 4 show the features of the methods. It was argued that when the collective methods are at the issue, management has an option to choose an estimate that gives a favourable result. The two methods can rarely produce the same estimate and managers usually choose the favourable one. Another problem is that the estimate itself can be influenced. By changing the rules of recognition or by ignoring the impact of economic circumstances of the current accounting year, management can practice earnings management. For example, when the volume of AR increases the riskiness will be also increased. A correct accounting practice requires that the estimates to be changed in response to the economic situations. By ignoring such a change the value of AR is not correctly accounted.

The study concludes that by exploiting the flexibility allowed by standards, managers can bolster the earnings or portrait the key ratios in a less risky fashion. A lack of proper categories for recognition, definition of AR alongside with alternative treatments at the practical level makes accounting of AR to appear troublesome in the future time. Additionally, the language style of standards allows management to project earnings path and avoid true and fair value accounting. The conclusion is that increasing development of "managed accounts" and inclusion of AR as part of managerial service platform creates a fear for witnessing an erosion in the quality of income statements and balance sheets. Finally by drawing on Epstein & Jermakowicz (2007); and Mathews (1993), the study concludes that the use of estimate increases problem of disclosure in accounting. A fair value accounting requires that valuation of AR to be carried out by means of estimate. The question that can be raised is that: how the use of estimate affects users' interpretation of accounts in decision making?

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Hossein Pashang, Jonkoping University, Sweden
Table 1: Source: United States General Accounting Office: Financial
Statement Restatements: Trends, Market Impacts, Regulatory
Responses, and Remaining Challenges (October 2002).

Major reasons                 Percents

Revenue recognition               37,9
Cost/expense                      15,7
Restructuring/assets/inventory     8,9
Acquisition/merger                 5,9
Security-related                   5,4
Reclassification                   5,1
Other                             20,7


Illustration 2: the procedures of judging the economic situations of
receivables

Procedures of judging uncertainties of AR

Nature of AR        Sources of                Legal treatments
                    documents

Ordinary AR         No indication of risk     No adjustments and
                                              reductions

Doubtful AR         Accountants' own          No adjustments and
                    information               reductions

Disputed AR         Customers' information    No adjustments and
                                              reductions

Uncollectible AR    Legal authorities'        AR and net income are
                    information               reduced

Nature of AR        Economic treatments

Ordinary AR         No adjustments and
                    reductions

Doubtful AR         Balance of AR and net
                    income are adjusted

Disputed AR         Balance of AR and net
                    income are adjusted

Uncollectible AR    AR and net income are
                    reduced and adjusted

Illustration 3: calculation of estimate by global method

Years    Net sale (SWED)    Bad depth    percentage

X1               520 000        10200         1, 96
X2               595 000        13900         1, 34
X3               585 000        9 900         1, 69

Total          1 700 000       34 000         2, 00

Illustration 4: presentation of aging method

Customers          Total        Not    1-30 days
                            yet due     past due

Customer a           150                     150
Customer b           400
Customer c         1 000        900          100
Customer d           250
Others            42 600     21 000       1 4000
Total             44 400     21 900       14 250
Estimate %                      1.0          2.0

Total allowance    2 459        219          285

Customers         31-60 days    61-90 days      Over 90
                    past due      past due    days past
                                                    due
Customer a
Customer b               400
Customer c
Customer d                             250
Others                 3 800          2200        1 600
Total                  4 200         2 450        1 600
Estimate %              10.0          30.0         50.0

Total allowance          420           735          800
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