Most businesses extend credit to some or all of their customers. In a perfect world, all of these customers will pay off their debts within the agreed upon timeframe.
In reality, not all customers will fulfill their payment obligations. Businesses must have structures and processes in place for responding to these challenges.
The tools utilized by the business to follow through on accounts receivable, and in particular, those that have gone unpaid, make up the business’s collections management.
Very few businesses conduct all of their transactions in cash. For the vast majority of businesses that receive payment in all different forms, some form of credit is often extended to the customer.
In business accounting, transactions for which the business has yet to receive payment in full are recorded in the general ledger as accounts receivable.
Accounts receivable are typically collected in two months or less. Ideally for the business, all accounts receivable will be collected in this standard amount of time.
Unfortunately, not all customers are reliable. For this reason, the business can and must take different measures to remind, encourage, and follow through with customers to receive full payment. These measures help the business ensure that uncollected debts are kept to a minimum.
Collections management refers to the systems, methods, and procedures that a business has in place to oversee collections of unpaid bills from customers, also known as accounts receivable collections.
Collections can take on many different approaches depending on the business, the customer, and the nature of the debt.
Collections management encompasses a range of measures. They begin at the earliest stages of accounts receivable:
For example, proper invoicingsupports collections. Invoices that are accurate and clear about the terms of payment will help to avoid confusion. The invoice should include all the terms that were agreed to at the point of the transaction.
Accounting automation greatly improves the process of accounts receivable collections. Accounting automation, also known as computerized accounting, refers to the use of software applications to perform the essential functions involved in the process of maintaining a business’s financial records.
Automation greatly reduces the time, labor, and costs involved in AR. Most importantly, it improves efficiency and accuracy, which helps improve collections.
Beyond these steps which lay the foundation for good collections, the business will also evaluate its accounts receivable by creating what is known as anaging report. An aging report will provide the business with a snapshot of the status of all of its accounts receivable.
The aging report organizes individual accounts receivable into groups depending on how much they are past due.
The typical groupings are:
More than 90 days
The status of each group reflects the time that has elapsed since an invoice was issued to the customer.
The aging report will help the business organize and evaluate the status of its accounts receivable.
Once a business has evaluated its accounts receivable, it can implement a strategy for collections. Accounts receivable teams use dunning letters to collect on overdue receivables and prevent accounts from going delinquent.
A dunning letter is a collection notice sent to a customer explaining that a payment they owe is overdue. They help the business communicate with its customers and prevent delinquent accounts.
Business can also take many steps to avoid having accounts receivable become past due. The business must move quickly on accounts receivable to avoid letting them go uncollected for a longer period of time.
Discounts for early payments, payment plans, and offering diversified options for receiving payments also help the business manage collections and keep uncollected payments to a minimum.
Despite the best efforts of the business, not all accounts receivable will be collected. Bad debt are loans or credit sales that the business determines can no longer be collected.
In order to account properly for bad debt, the business must record it as an expense.
Because a business does not typically know that an account receivable will not be collected until sometime later, it will instead estimate how much bad debt will occur.
Businesses typically estimate their bad debt according to the allowance method, which involves setting aside a reserve for expected bad debts or so-called doubtful accounts.
This reserve, or allowance, is also referred to as a contra asset account because it nets or balances against the accounts receivable assets listed in the balance sheet.
Although it is based on an estimate, this method allows a business to align bad debt to the reporting period in which the sale occurs. This is in accordance with the matching principal, and therefore, it is considered a more accurate form of accounting bad debt expenses.
If bad debt is later collected, it is recorded as a bad debt recovery.
Accounts Receivable Aging Report
Accounts Receivable Assets
Accounts Receivable Collections
Accounts Receivable Dispute Resolution
Accounts Receivable Journal Entry
Accounts Receivable Reporting
Accounts Receivable Turnover Ratio Balance Sheet
Cash Flow Forecast
Chart of Accounts
Collection & Recovery
Days Sales Outstanding (DSO)
Debits & Credits
Depreciation Journal Entry
Month End Close Process
Businesses measure their collections by calculating the accounts receivable turnover ratio. This ratio measures how effectively the business converts outstanding debt from customers into completed payments. In other words, it measures how effectively the business is managing its collections.
Businesses also measure collections by calculating the Days Sales Outstanding (DSO), which refers to the average number of days it takes a business to collect payment for products and services provided. DSO is generally taken as a measure of the business’s efficiency and its effectiveness at converting sales to actual revenue, or cash. The lower the DSO, the more efficiently the business is operating.
All businesses that extend credit to their customers accept the risk that comes with this practice. However, the business must still manage its collections to keep defaults, or bad debt, to a minimum.
A business that does not have effective collections management will not have sufficient cash flow and will not be able to meet its basic obligations.