Definition of 'Accounts Receivable'

Definition: Accounts Receivable (AR) is the proceeds or payment which the company will receive from
its customers who have purchased its goods & services on credit. Usually the credit period is short
ranging from few days to months or in some cases maybe a year. 

Description: The word receivable refers to the payment not being realized. This means that the
company must have extended a credit line to its customers. Usually, the company sells its goods and
services both in cash as well as on credit. 

When a company extends credit to the customer, the sale is realized when the invoice is generated, but
the company extends a time period to the customers to pay the amount after some time. The time
period could vary from 30-days to a few months. 

Account Receivables (AR) are treated as current assets on the balance sheet. Let's understand AR with
the help of an example. Suppose you are a manufacturer M/S XYZ Pvt Ltd and you manufacture tyres.  

A customer gives you an order of Rs 1,00,000 for 100 tyres. Now, when the invoice is generated for that
amount, sale is recorded, but to make the payment the company extends the credit period of 30-days to
the customer. 

Till that time the amount of Rs 1,00,000 becomes your account receivable because the customer will pay
that amount before the period expires. If not, the company can charge a late fee or hand over the
account to a collections department. 

Once the payment is made, the cash segment in the balance sheet will increase by Rs 1,00,000, and the
account receivable will be decreased by the same amount, because the customer has made the
payment. 

The amount of account receivable depends on the line of credit which the customer enjoys from the
company. Usually, this is offered to customers who are frequent buyers.
The objective of managing accounts receivable is for a business to simply get paid. Faster.
Accounts receivables are the debtors in your business that have been issued goods or services on credit
- the customer agrees to pay at a time stipulated in the future. Unfortunately, late payments are
common, and cause cash flow problems for businesses - they may become cash strapped and unable to
pay their own bills, wages, or plan for growth.

Managing accounts receivables becomes a key function in business. We all understand that improving
sales is good for business, but making the cash collection is equally important because until you get paid,
you haven’t capitalised on the sale (but you’ve incurred the cost of making the sale).

Accounts receivable management should be proactively managed:

Proactive: Have a pre-determined system in place that includes risk assessment of potential bad debts,
consequences for late payment (how does the business chase payment?) and prompts you to stay ahead
of credit control. Make it easy to pay you (for example, collect money online).

Determinants Of Investment In Receivables

The size of investment in receivables is influenced by number of factors. Among them

two factors, the volume of credit sales, and the average length if time between sales and
collection are important.
To illustrate, suppose National Enterprise, a newly established firm makes a credit sales
of $ 5000 per day and its customers are allowed 15 days of credit. At the start of
business i.e. in the first day, it sold $ 5000 on credit so that its end-of-day accounts
receivables stand $ 5000 in the firm's book. During the second day, it sold another $
5000 on credit increasing the book receivables to $10,000. If it goes on granting a credit
of $ 5000 per day for 15 days, its account receivable will increase to $ 75,000 at the end
of 15th day. However in 16th day it will make another $ 5000 credit sales, but payments
for sales made on first day will reduced receivables by $ 5000, so that total account
receivable will remain constant at $ 75000 in 16th day and the each day thereafter
throughout the year. The average account receivable the firm must carry during the year
is, therefore $ 75000.
Account receivable = Credit sales per day X Average length of collection period
= $ 5000 X 15 days = $ 75000.

Above illustration shows that the change in credit sales or change in collection period or
both will affect the investment in account receivable. However in turn, the volume of
credit sales and collection is affected by several factors such as industrial norms, credit
standards, credit terms, collection policy, payment habits of customers, nature of
business, size of enterprise, cost of investment in receivables and so on. Therefore, the
financial manager must be able to look in depth and analyze the impact of these factors
in volume of sales and the cost-benefit trade off associated to credit decisions.
Collection Policies & Procedures
Accounts receivable payments are a major contributor to liquidity, cash flow and the working capital
requirements of a business. On-time payments keep the business cycle flowing and make it possible for
a business to meet operational and short-term debt obligations. Strict collection policies and procedures
that encourage customers to pay can result in fewer bad debts, better cash flows and an increase in
business profitability.
Objectives

Accounting standards consider accounts receivable a business asset and require they be recorded in the
asset section of a balance sheet. Write-offs not only decrease business assets but also increase bad debt
expenses. The objective of creating collection policies and procedures is to encourage customers to pay
on time and collect past due accounts within the 30 to 90 day time frame the business typically sets
before considering past due accounts not collectible, writing them off and turning them over to a
collections agency.

Evaluating Management of Accounts

Receivables:
In any business it is a usual practice to provide credit to your customers. Granting credit
helps the business in increasing sales but at the same time also increases the risk of
uncollectible accounts.

The company needs to actively manage and monitor the accounts receivables and
evaluate how well the company is managing its receivables. The regular monitoring
involves keeping a continuous tab on the outstanding receivables balances, and
reporting any deviation from the normal practice. The two important performance
measurement reports are Accounts Receivable Aging Schedule and Day’s Sales
outstanding.

1. Days of Sales Outstanding (DSO)

Also known as the Average Collection Period, DSO is calculated by dividing Average
Accounts Receivables by Average daily sales.

The Days of Sales Outstanding tells us on an average how much time it takes to collect

the receivables (Time lag). Following analysis can be made from the calculated ACP.
Below are a few important points about DSO.
  Indicates how quickly the receivables are collected.
 A lower DSO indicates that the company is taking lesser time to collect its
receivables.
 A high DSO implies poor credit/collect policy.

Example

A firm provides 30 days credit period as per their credit policy. Their DSO for the first
three quarters is 60 days, 50 days, and 45 days.

From this data we can say that the company has not been able to collect money as per
its credit policy (30 days credit) in all three months. However, the trend of the three
months shows that the efforts in collecting funds are improving as the Daily Sales
Outstanding are coming down.

This method suffers from two limitations. One is that it aggregates all accounts
receivable ignoring individual accounts collection. And the other is, sales keep varying
that will not give the accurate picture though based on the average.

2. Accounts Receivables Aging Schedule

This is one of the key reports used by the accounts receivables managers. The report
provides a breakdown of the accounts receivables based on the days outstanding. This
breakdown helps the firm in organizing its collection efforts. For example, the accounts
that are outstanding for a longer period will need to be collected on priority. The
standard breakdown for accounts receivables is ‘<30 days due’, ’31-60 days due’, 61-90
days due’ days, ‘above 90 days due’.

This data can also be compared with the company’s past performance or its competitors
to notice the key trends. Generally, a huge percentage of accounts receivables in a
higher bracket indicate poor management of receivables and a weak credit policy.

Accounts receivable controls

Controls over accounts receivable really begin with the initial creation of a customer invoice, since
you must minimize several issues during the creation of accounts receivable before you can have a
comprehensive set of controls over this key asset. Controls then span the proper maintenance of
accounts receivable, and their elimination through either payments from customers or the
generation of credit memos. The key controls to consider are:

 Require credit approval prior to shipment. You will have problems collecting accounts
receivable if an order is shipped to a customer with a bad credit rating. Therefore, require the signed
approval of the credit department on all sales orders over a certain dollar amount.
 Verify contract terms. If there are unusual payment terms, verify them before creating an
invoice. Otherwise, accounts receivable will contain invoices that customers refuse to pay.
 Proofread invoices. If an invoice for a large-dollar amount contains an error, the customer
may hold up payment until you send a revised invoice. Consider requiring the proofreading of larger
invoices to mitigate this problem.
 Authorize credit memos. People who have access to incoming customer payments could
intercept incoming cash and then create a credit memo to cover their tracks. One step in the
prevention of this problem is to require the formal approval of a manager for credit memos, which
are then verified at a later date by the internal auditstaff. Do not take this control to extremes and
require approval for extremely small credit memos - allow the accounting staff to create small ones
without approval, just to clean up small remaining account balances.
 Restrict access to the billing software. As just noted, someone could intercept incoming
payments from customers and hide the theft with a credit memo. You should password-protect
access to the billing software to prevent the illicit generation of credit memos.
 Segregate duties. As just noted, no one should be able to handle incoming customer
payments and create credit memos, or else they will be able to take the money and cover their tracks
with credit memos. Therefore, assign these tasks to different people.
 Review accounts receivable journal entries. Accounts receivable transactions almost always
go through a sales journal in the accounting software that generates its own accounting entries.
Therefore, there should almost never be a manual journal entry in the accounts receivable account.
You should investigate these entries carefully.
 Audit invoice packets. After invoices are completed, there should be a packet on file that
contains the sales order, credit authorization, bill of lading, and an invoice copy. The internal audit
staff should review a selection of these packets to verify that the billing clerk properly reviewed all of
the supporting paperwork and correctly generated an invoice.
 Match billings to shipping log. It is possible that items will be shipped without a
corresponding invoice, or vice versa. To detect these situations, have the internal audit staff compare
billings to the shipping log, and investigate any differences.
 Audit the application of cash receipts. The accounting staff may incorrectly apply cash
receipts to open invoices, perhaps not even applying them to the accounts of the correct customers.
Have the internal audit staff periodically trace a selection of cash receipts to customer invoices to
verify proper cash application.