Accounts receivable is the amount owed to a company resulting from the company providing goods and/or services on credit. The term trade receivable is also used in place of accounts receivable.
The amount that the company is owed is recorded in its general ledger account entitled Accounts Receivable. The unpaid balance in this account is reported as part of the current assets listed on the company’s balance sheet.
When goods are sold on credit, the seller is likely to be an unsecured creditor of its customer. Therefore, the seller should be cautious when selling goods on credit.
Good accounting requires that an estimate should be made for any amount in Accounts Receivable that is unlikely to be collected. The estimated amount is reported as a credit balance in a contra-receivable account such as Allowance for Doubtful Accounts. This credit balance will cause the amount of accounts receivable reported on the balance sheet to be reduced. Any adjustment to the Allowance account will also affect Uncollectible Accounts Expense, which is reported on the income statement.
Example of Accounts Receivable
A manufacturer will record an account receivable when it delivers a truckload of goods to a customer on June 1 and the customer is allowed to pay in 30 days. From June 1 until the company receives the money, the company will have an account receivable (and the customer will have an account payable).
Cost of Maintaining Receivables
Maintaining receivables bears cost. It includes cost of investment in receivables, bad debt losses, collection expenses and cash discount. Costs related with receivables and their calculation are as follows:
Cost Of Investment In Receivables
This is the opportunity cost of funds being tied up in receivables, which would otherwise have not been incurred if all sales were in cash. The cost of investment in receivable is calculated as:
Cost of receivables = Investment in receivables X Opportunity costs
investment in receivables = (FC+ VC)/Days in year) X DSO
Where, FC = Fixed Cost, VC = Variable Cost and DSO = Days sales outstanding.
Bad Debt Losses
This is the loss due to default customers. Extension of credit to low quality-rate customers results into increase in bad debt losses. Bad debt losses are calculated as a percentage on sales as shown in equation below:
Bad debt losses = Annual credit sales X Percentage default customer
This is the cost incurred for operating and managing the collection and credit department of a firm. This includes the administrative cost of credit department, salary and commission paid to collection staff, cost paid for telephone and communication and so on.
It is the cost incurred to induce the customer for early payments of their accounts. A firm can offer cash discount to its customers to reduce the average collection period, bad debt losses, and the cost of investment in receivables. The discount cost is calculated as cash discount percentage multiplied by sales to discount customers as given below:
Discount Cost = Annual credit sales X Percentage discount customer X Percentage cash discount
Objectives of Receivables Management
Following are the objectives of receivables management which will help us to understand the purpose of receivables:
1. To optimize the amount of sales
2. To minimize cost of credit
3. To optimize investment in receivables.
4. To increase credit sales.
Therefore, the main objective of receivable management is to create a balance between profitability and cost.
What are the areas covered by receivables management?
Following are the areas covered by receivables management:
– Credit Analysis
– Credit Terms
– Financing of Receivables
– Credit Collection
– Monitoring of Receivables