What is Accounts Receivable Process?
Accounts Receivable is a type of account which represents an amount receivable by the organization from their customers. The organizations can be engaged in the supply of goods or services. The consideration for such supply may either be received at the time when such a transaction takes place or sometimes at a later date. Where the consideration is received at a later date, then during the period between supply and payment date, such amount is shown by the organization as Accounts Receivable. It forms part of the assets of the company and generally classified under current assets. Let’s understand, the overview of the accounts receivable process with examples.
Example of Accounts Receivable Process
ABC Pvt. Ltd. sold goods to Mark Inc. worth $ 1,000 on 15 February 2019 and the company allowed credit to Mark Inc. for 3 months and after that simple interest will be charged @ 2% monthly and if payment was received earlier than 3 months then 5% discount will be allowed.
Situation #1
Now as apparent, the accounts receivable process starts only when supply was made on credit. Inventory should be reduced with the quantity supplied. To record the sale in books, an account with the name ‘Mark Inc.’ should be created in the system and invoice must be issued after mentioning of agreed terms.
The journal entry would be passed in the books as:
In the above journal entry, Market Inc. is shown under account receivable grouping as current assets in the balance sheet until the payment was received. And sales booked shown under an income statement.
Total Cash Flow in this situation will be Zero as the supply was made on credit.
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Situation #2
Now, if payment is received before completion of 3 months, let’s suppose 15th April 2019 then as agreed 5% discount will be given to the customer and the same would be recorded in books by passing journal entry as under (hit 3 accounts simultaneously)
For the above entries,
- Bank/Cash – Net payment will be received after deducting of discount.
- $50 – is the expense for the company shown under income statement
= $1000 * 5%
= $50
- $1000 – Account receivable will be zero being amount realized
The total cash inflow in this situation will be $950 as the payment was realized early after the deduction of discount.
Situation #3
If payment is not realized within 3 months, then the company have to follow up by sending reminders for payment and let’s suppose, the amount was received on 15th May 2019 then as agreed 2% monthly interest will be charged from customer and would be recorded in books by passing journal entry as under (hit 3 accounts simultaneously):
For the above entries,
- Bank/Cash – Payment will be received including of late payment interest charged
- $20 – Income for the company shown under income statement
= $1000 * 2%
= $20 - $1000 – Account receivable will be zero being amount realized
The total cash inflow in this situation will be $1,020 as the payment was realized late including of late payment interest.
Situation #4
If payment is not realized for a long time or let just say there is no certainty of receiving the same either in full or part, then the amount shown as account receivable will be considered as bad debts to the extent of non-realization of the amount. (Bad debts as the name advises, the debts or account receivable which turns into bad).
Suppose in the above example, if Mark Inc. says that they become insolvent and have the capacity to pay only 40% amount, then the remaining 60% will be booked as bad debts expense and would be recorded in books by passing journal entry as under (hit 3 accounts simultaneously)
For the above entries,
- Bank/Cash – Net Payment to the extent realized
- $600 – Expense for the company shown under income statement or it can be deducted out of sales and net sales/income will be shown in the income statement.
= $1000 * 40%
= $400 - $1000 – Account receivable (i.e. the account of Mark Inc. in the books of a company) will be zero as an amount to the extent realized is booked under bank/cash account and the amount to the extent non-realizable is being booked as bad-debts expenses.
The total Cash inflow in this situation will be $400 as the remaining payment was turned into bad debts.
Completion of Accounts Receivable Process
The accounts receivable process ends when the amount is received from the customer. Basis the industry trends, companies usually make supplies on credit. As per the accounting principles, companies have to recognize such recoverable amounts as accounts receivables. However, how fast a company can turn its receivables into cash, indicates a company’s performance. Accounts receivable are also used for measuring various ratios. One of the very important ratios is Accounts Receivable to Sales ratio.
For example, if any company has an annual turnover of $ 1,000,000. Accounts receivables on the balance sheet date are $20,000. In this case, accounts receivable to sales ratio of the company will be 20,000*100/1,000,000 i.e. 2.
If the company has a lower ratio as compared to the average ratio of the industry, it means a company is able to recover the amount from its customer faster than the others. A lower accounts receivable to sales ratio is better for the liquidity of the company.
Conclusion
It is apparent that if the company has an efficient accounts receivable process, then it has a better cash position and it positively impacts marketing, sales, customer service, and overall operations. For a faster process of account receivable, the company usually adopts different methods like discounts to customers on early payment, outsourcing, and factoring of debtors. The company can always start a collection process early by sending reminders and can short the credit period. Factoring services can be used in cases where immediate cash requirement arises as the company sells its account receivable to another party at discount and gets immediate cash. Also, through outsourcing, the third party realizes the payment from debtors on behalf of the company and charges a commission for its services.
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