[Opinion] Allowance for Doubtful Accounts as a Risk Management Cost

Seo Ji-yong, Professor, Department of Business Administration, Sangmyung University

The calculation of eligible costs by credit card companies is scheduled for the second half of this year. Eligible costs are expenses that determine the merchant fee rates of card companies, calculated every three years based on funding costs, risk management costs, general administrative costs, and others. For reference, financial authorities and the card industry have been recalculating eligible costs every three years since 2012 to set merchant fee rates. Around this time, there is a need to revisit discussions on the allowance for bad debts, which was excluded from risk management costs during the 2018 merchant fee rate restructuring. The allowance for bad debts is a statutory reserve additionally set aside when the bad debt provision, accumulated based on international accounting standards, falls short for supervisory purposes. This allowance is established when the likelihood of non-performing loans increases and is reversed when the borrower's creditworthiness improves. It serves the same risk management function as the bad debt provision.

The amount of allowance for bad debts set aside by full-line card companies in the first quarter of this year increased sharply compared to the same period last year. In the first quarter of 2020, there was a reversal of 280 million KRW in allowance for bad debts, but in the first quarter of this year, 290 billion KRW was set aside. As a result, net income for the first quarter of this year decreased by about 40% after reflecting the allowance for bad debts compared to before its reflection. Ultimately, costs to prepare for future risks of card companies increased, leading to reduced profitability. Since the increased net income from installment finance revenue growth and reduced recruitment costs was offset by the allowance for bad debts set aside, it is appropriate to recognize this as a risk-related cost. The allowance for bad debts is generally set aside because the supervisory requirement for bad debt provisions, which recognize future risks under different standards compared to other financial sectors, is large.

Other financial sectors consider high-interest loans as risky loans and set aside bad debt provisions accordingly. However, in the card industry, an additional 30% bad debt provision is required based on whether a borrower uses two or more card loans. In reality, the proportion of borrowers using multiple card loans is increasing, but delinquency rates are gradually decreasing. Therefore, the supervisory authority’s inappropriate requirement for bad debt provisions to cover expected future losses results in an increase in the allowance for bad debts set aside.

Meanwhile, under the current Article 25-4 of the Specialized Credit Finance Business Act, costs incurred to provide benefits to credit card merchants are stipulated to be borne by the respective merchants. If the allowance for bad debts is defined as an additional cost due to increased credit risk, it would not align with the definition of eligible costs for the card company to bear the entire expense. This is because large merchants also sufficiently benefit from sales increases generated through credit sales conducted for consumer promotion purposes, such as large-scale promotional events.

In conclusion, improving the calculation of risk management costs is necessary for a reasonable calculation of eligible costs. It is desirable to revise the bad debt provision standards to recognize future risks linked to interest rate levels rather than the presence of multiple card loan borrowers. In other words, instead of defining high-risk loans based on whether a borrower has multiple card loans, the standard should be changed so that bad debt provisions are set according to high-interest rate levels. Additionally, the allowance for bad debts should be reflected as part of risk management costs when calculating eligible costs. In particular, a method should be considered to share the portion of the allowance for bad debts that reduces card companies’ profitability as risk management costs with large merchants such as department stores and large discount marts that enjoy credit provision benefits.

Seo Ji-yong, Professor, Department of Business Administration, Sangmyung University

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