Account Receivables

Defining Accounts Receivable

Every business sells products or services to its customers. Accounts receivable represents money entities owe to the firm on the sale of products or services on credit. In most businesses, accounts receivable are executed by generating an invoice and either mailing or electronically delivering it to the customer. In turn, the customer must pay the invoice within an established timeframe, which is called the credit terms or payment terms. The accounts receivable departments use the sales ledger, which normally records:

• The sales a business has made
  
  
• The amount of money received for goods or services
  
  
• The amount of money owed at the end of each month (debtors)

Bookkeeping

On a company's balance sheet, accounts receivable are the money owed to that company by entities outside of the company. The receivables owed by the company's customers are called trade receivables. Account receivables are classified as current assets, assuming they are due within one year. Management is concerned with these funds when considering working capital requirements.

Companies have two methods available to them for measuring the net value of accounts receivable, which is generally computed by subtracting the balance of an allowance account from the accounts receivable account. The first method is the allowance, which establishes an allowance for doubtful accounts or bad debt provisions that reduce the accounts receivable balance. The amount of the bad debt provision can be computed in two ways:

1. By reviewing each debt and deciding whether it is doubtful (a specific provision)
   
   
2. By providing for a fixed percentage (e.g., 2%) of total debtors (a general provision)

The second method is the direct write-off method. It is simpler than the allowance method because it allows for one simple entry to reduce accounts receivable to its net realizable value. The entry would consist of debiting a bad debt expense account and crediting the respective accounts receivable in the sales ledger.

Revenue Recognition

A company can choose when to recognize revenue via various accounting methods. Revenue has a big impact on bottom-line profitability, so managers may be tempted to "manage" revenue recognition. Under accrual accounting, a firm can recognize revenue when it has:

• Delivered goods, and the title is transferred to the buyer.
  
  
• Performed all, or a substantial portion of, the services to be provided.
  
  
• Incurred a substantial majority of the costs, and the remaining costs can be reasonably estimated.
  
  
• Received either cash, a receivable, or some other asset for which a reasonably precise value can be assigned or collectibility is reasonably assured.

Managers can sometimes tweak the period revenue is recognized to create a more attractive financial statement for a given circumstance.

Accrual Recognition This chart lays out methods for accruing revenue and expenses in accounting.

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Setting a Credit Policy

There are three steps a company must undergo when developing a credit policy:

1. Establish credit standards.
   
   
2. Establish credit terms.
   
   
3. Establish a collection policy.

Management must decide on credit standards, which involves decisions on how much credit risk to assume. These decisions play a large role in determining how much money a firm ties up in its receivables. A restrictive policy will likely result in lower sales, but the firm will have a smaller receivable investment and incur fewer bad debt losses. Less restrictive policies will generate higher sales and a higher receivables balance. Still, the company will most likely incur more bad debt losses and a high opportunity cost of holding capital in accounts receivables.

Credit Score Factors This chart depicts the factors that affect an individual's credit score.

Another important factor in determining credit standards involves a company evaluating an individual or business's creditworthiness, or credit score. This refers to the risk that the buyer will default on extended credit by failing to make payments, which it is obligated to do.

Potential losses include the selling price, disruption to cash flows, and increased collection costs. To reduce its risk, the seller may perform a credit check on the buyer or require the buyer to put up collateral against the credit extended.

Other Facets of Credit Policies

After establishing credit standards, the firm must decide on the period that would be allowed before payment must be made and whether or not they will offer a discount for early payments. If a discount is offered, the discount amount must also be determined. There are many purposes for discounting, such as to move out-of-date stock, to reward valuable customers, as a sales promotion, or to reward behaviors that benefit the discount issuer. Some common types of discounts include:

• Prompt payment discount.
  
  
• Preferred payment discount (such as cash over credit card).
  
  
• Partial payment discount.
  
  
• Seasonal discount (such as orders placed in a slack period).
  
  
• Trade discount (usually given when the buyer agrees to perform some function).
  
  
• Quantity discount.

The last step is to establish a collection policy. Collection policies vary widely among industries. Some companies do nothing when their customers don't pay. Others send out reminders notifying customers that their payments are late. Some companies may even take legal action at the first late payment.

The Five C's Of Credit

1. Character: Is the borrower trustworthy and has a history of meeting debt obligations?
   
   
2. Capacity: Will the borrower have enough cash flow to make its payments?
   
   
3. Capital: Does the borrower have enough capital to justify the loan?
   
   
4. Collateral: Does the borrower have any assets that can secure the loan?
   
   
5. Conditions: How are the borrower and the economy performing, and how are they expected to perform?

Terms of Trade

Credit terms are often quoted as "net X," with X being a certain number of days. An example of a common payment term is Net 30, which means payment is due at the end of 30 days from the date the invoice is issued. Transit time is included when counting the days, i.e., a purchase in transit for 7 days before receipt has just 23 additional days until payment is due from the seller.

Other common payment terms include Net 45, Net 60, and 30 days at the end of the month. Net 30 is a term that most businesses and municipalities (federal, state, and local) use in the United States. Net 10 and Net 15 are also widely used. Net 60 is less used because of its longer payment terms.

The debtor is free to pay before the due date, and some businesses offer a discount for early payment. A discount can be offered and stated as "2/10, net 30."

This means the buying firm will receive a two percent discount if it pays by the tenth day. Otherwise, they will pay the full amount in 30 days.

Let's consider a potential case of the operator of an ice cream stand. The operator may sign a franchising agreement, under which the distributor agrees to provide ice cream stock under the terms "Net 60" with a ten percent discount on payment within 30 days and a 20% discount on payment within 10 days.

This means the operator has 60 days to pay the invoice in full. If sales are good within the first week, the operator may be able to send a check for all or part of the invoice and make an extra 20% on the ice cream sold. However, if sales are slow, leading to a month of low cash flow, then the operator may decide to pay within 30 days, obtaining a 10% discount, or use the money another 30 days and pay the full invoice amount within 60 days.

The ice cream distributor can do the same thing, receiving trade credit from milk and sugar suppliers on terms of Net 30, a 2% discount if paid within ten days. Under this agreement, they are apparently taking a loss or disadvantageous position in this web of trade credit balances.

Why would they do this? First, they have a substantial markup on the ingredients and other production costs of the ice cream they sell to the operator. The markup is the portion of the selling price added to the cost of obtaining the inventory. In addition, it is not in the distributor's best interest for customers to go out of business due to cash flow instabilities, so its financial terms aim:

Markup This equation shows the selling price for a vendor calculated by adding its markup to its cost.

1. Allow start-ups the ability to manage their inventory investments – effectively giving them a short-term business loan.
   
   
2. By tracking which customers pay and when, the distributor can identify developing problems and take steps to reduce or increase its trade credit.

Collecting Receivables

Collecting accounts receivable is the final step in the credit extension process and arguably the most difficult. When dealing with collections, a firm needs to start by monitoring its accounts receivable to determine whether its policy is working to the company's advantage. Accounts receivable days and an aging schedule are the most common monitoring tools.

Accounts Receivable Days

Accounts receivable days are the average number of days a firm takes to collect on its sales. By comparing this number to the number in the credit policy, a business can determine whether its policy is effective.

Accounts receivable days are important because investors use this measure to evaluate a firm's credit management policy. However, this method has weaknesses. Seasonal sales patterns may cause accounts receivable days to change depending on when the calculation occurs. Therefore, management can potentially manipulate accounts receivable days to hide important information.

Aging Schedule

The other commonly used method is an aging schedule, which categorizes accounts by the number of days they have been on the books. It can be constructed using the number of accounts or the dollar amount of the outstanding accounts receivable. If the percentages in the lower half of the schedule begin to increase, the firm needs to evaluate the effectiveness of its credit policy.

Payment patterns provide information on the percentage of monthly sales the firm collects each month after the sale. This information can be used to forecast the business's working capital needs.

Receivable Turnover Ratio

Another way to evaluate a credit policy is to examine the receivable turnover ratio. This financial ratio measures the average number of times receivables are collected.

Collecting Receivables

Collection Letter This is an example of a letter from a collection agency offering to settle a debt.

Companies can use several methods to collect their outstanding receivables. Some do nothing, some send reminders notifying customers of late payments, and some take legal action – sometimes at the first late payment. If firms so choose, they can use a collection agency. A collection agency is a business that pursues payments of debts owed by individuals or businesses.

Most collection agencies operate as agents of creditors and collect debts for a fee or percentage of the total amount owed. There are many types of collection agencies. First-party agencies are often subsidiaries of the original company to whom the debt is owed.

Third-party agencies are separate companies contracted by a business to collect debts on their behalf for a fee. A company may protect against bad debt losses by purchasing trade credit insurance. This is an insurance policy and a risk management product offered by private insurance companies and governmental export credit agencies to business entities wishing to protect their accounts receivables from loss due to credit risks like protracted default, insolvency, or bankruptcy.