Defining Accounts Receivable
Accounts receivable represents money owed by entities to the firm on the sale of products or services on credit.
Describe when a business can recognize revenue
- In most businesses, accounts receivable is executed by generating an invoice and either mailing or electronically delivering it to the customer, who, in turn, must pay it within an established timeframe.
- Account receivables are classified as current assets assuming that they are due within one year.
- Revenue has a big impact on bottom-line profitability, so managers may be tempted to “manage” revenue recognition.
- accrual accounting: A method of accounting in which funds are recorded when they are earned and deductions are claimed when expenses are incurred.
Defining Accounts Receivable
Every business sells products or services to its customers. Accounts receivable represents money owed by entities to the firm on the sale of products or services on credit. In most businesses, accounts receivable is 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 )
On a company’s balance sheet, accounts receivable is 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 that they are due within one year. These are the funds management is concerned with 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 method, which establishes an allowance for doubtful accounts, or bad debt provision, that has the effect of reducing the balance for accounts receivable. The amount of the bad debt provision can be computed in two ways:
- By reviewing each individual debt and deciding whether it is doubtful (a specific provision)
- 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 in that 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.
A company has a choice of when to actually 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 in which revenue is recognized to create a more attractive financial statement for a given circumstance.
Setting a Credit Policy
To establish a credit policy, a company must establish credit standards, credit terms, and a collection policy.
Analyze a potential borrower using the “Five C’s of Credit”
- Management must decide on credit standards, which involves decisions on how much credit risk to assume.
- Another important factor in determining credit standards involves a company evaluating the credit worthiness of an individual or business.
- After establishing credit standards, the firm must decide on the length of the period before payment must be made and whether or not they will offer a discount for early payments.
- The last step is to establish a collection policy.
- bad-debt losses: losses resulting from an uncollectible debt.
- collection policy: the set of rules for receiving accounts payable or debt
- credit period: the amount of time required to receive payment for debt extended
- collateral: A security or guarantee (usually an asset) pledged for the repayment of a loan if one cannot procure enough funds to repay. (Originally supplied as “accompanying” security. )
Setting a Credit Policy
There are three steps a company must undergo when developing a credit policy:
- Establish credit standards.
- Establish credit terms.
- 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 most likely result in lower sales, but the firm will have a smaller investment in receivables and incur less bad- debt losses. Less restrictive policies will generate higher sales as well as a higher receivables balance, but the company will most likely incur more bad-debt losses and a high opportunity cost of holding capital in accounts receivables.
Another important factor in determining credit standards involves a company evaluating the credit worthiness, or credit score, of an individual or business. 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 not only include the selling price, but can also include 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 credit extended.
Other Facets of Credit Policies
After establishing credit standards, the firm must decide on the length of 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 amount of the discount 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 (for orders placed in a slack period for example).
- 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 a reminder notifying customers that their payment is late. Some companies may even take legal action at the first late payment.
The Five C’s Of Credit
- Character: Is the borrower trustworthy with a history of meeting its debt obligations?
- Capacity: Will the borrower have enough cash flow to make its payments?
- Capital: Does the borrower have enough capital to justify the loan?
- Collateral: Does the borrower have any assets that can secure the loan?
- Conditions: How are both the borrower and the economy performing and how are they expected to perform?
Terms of Trade
Terms of trade credit include the amount of time allowable for payment to be received, including any potential discounts.
Differentiate different types of transaction by the terms of trade
- Credit terms are often quoted “net X” with X being a certain number of days.
- An example of a common payment term is Net 30, which means that payment is due at the end of 30 days from the date the invoice is issued.
- The debtor is free to pay before the due date, and many businesses can offer a discount for early payment.
- A discount stated as 2/10, net 30 means that the buying firm will receive a two percent discount if it pays by the tenth day, or else they will pay the full amount in 30 days.
- franchising: The establishment, granting, or use of a franchise.
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 that 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 to the seller.
Other common payment terms include Net 45, Net 60 and 30 days end of month. Net 30 is a term that most business and municipalities (federal, state and local) use in the United States. Net 10 and Net 15 is widely used as well. 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 that 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 that 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, 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 costs of production of the ice cream they sell to the operator. The markup is the portion of 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:
- To allow start-ups the ability to manage their inventory investments – effectively giving them a short-term business loan.
- By tracking which customers pay, and when, the distributor can identify problems that are developing and take steps to reduce or increase its amount of trade credit.
Companies use different methods to collect their outstanding receivables, like sending out reminders or employing a collection agency.
Describe the different ways a company can analyze its collections
- Collecting on accounts receivable is the final step in the credit extension process, and arguably the most difficult.
- Accounts receivable days and an aging schedule are tools used to monitor accounts receivable.
- The accounts receivable days is the average number of days that it takes a firm to collect on its sales. The aging schedule categorizes accounts by the number of days they have been on the books.
- A company may protect against bad- debts losses by purchasing trade credit insurance.
- creditors: a person or institution to whom money is owed.
- subsidiary: A company owned by the parent company or holding company
Collecting upon accounts receivable is the final step in the credit extension process, and arguably the most difficult. In dealing with collections, it is important for a firm to start by monitoring its accounts receivable in order to determine whether its policy is working to the best advantage of the company. Accounts receivable days and an aging schedule are the most common monitor tools used.
Accounts Receivable Days
The accounts receivable days is the average number of days that it takes a firm 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 or not. The accounts receivable days is important because investors utilize this measure to evaluate a firm’s credit management policy. This method does have its 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.
The other method commonly used is an aging schedule which categorizes accounts by the number of days they have been on the books. It can be constructed in one of two ways: using the number of accounts or using 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 that the firm collects each month after the sale. The payment pattern can be used to forecast the working capital needs for the business.
Receivable Turnover Ratio
Another way to evaluate a credit policy is to look at the receivable turnover ratio. This is a financial ratio that measures the number of times, on average, receivables are collected during a period.
There are several methods companies can use to collect their outstanding receivables. Some do nothing, some send out reminders notifying customers of late payment, and some take legal action – sometimes at the first late payment. If firms so choose, they can utilize 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 oftentimes a subsidiary 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-debts 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.