What is the Accounts Receivable Process?
Accounts Receivable Process consists typically of four steps were first the company has to decide its Credit Practices for customers, second, invoicing of the goods sold to them, next is to track the payments received and yet to be received and lastly, recording of the Accounts Receivables balances by the accounts department.
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 of transaction taking 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 ReceivableAccounts ReceivableAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.read more. It forms part of the assets of the company and generally classified under current assets.
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For eg:
Source: Accounts Receivable Process (wallstreetmojo.com)
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 Simple InterestSimple interest is interest determined on a person's principal amount borrowed. It is determined by multiplying the principal amount borrowed by the interest rate and the time period for which interest is charged.read more 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, this 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 the 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 Current Assets In The Balance SheetCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more until the payment was received. And sales booked shown under an income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more.
Total Cash FlowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more in this situation will be Zero as the supply was made on credit.
Situation #2
Now, if payment is received before completion of 3 months, let’s suppose 15 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 the discount.
Situation #3
If payment is not realized within 3 months, then the company has to follow up by sending reminders for payment, and let’s suppose the amount was received on 15 May 2019, then as agreed, 2% monthly interest will be charged from customer. It 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 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 debtsBad DebtsBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation.read more 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 can pay only 40% amount, then the remaining 60% will be booked as bad debts expense and would be recorded in books bypassing 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
It 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 amountsRecoverable AmountsThe recoverable amount of an asset is the present value of the expected cash flows that will result from the asset's sale or use, and is determined as the greater of two amounts: the asset's fair value as reduced by related selling costs, and the asset's value in use.read more 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 critical ratios is the 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 can recover the amount from its customer faster than the others. A lower accounts receivable to sales ratio is better for the liquidity of the companyLiquidity Of The CompanyLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.read more.
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 faster processing, 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 periodThe Credit PeriodCredit period refers to the duration of time that a seller gives the buyer to pay off the amount of the product that he or she purchased from the seller. It consists of three components - credit analysis, credit/sales terms and collection policy.read more. Factoring services can be used in cases where immediate cash requirement arises as the company sells its account receivable to another party at a discount and gets instant cash. Also, through outsourcing, the third party realizes payments from debtorsDebtorsA debtor is a person or entity that owes money to the other party in a transaction. The receiver is referred to as the creditor, and the payment terms vary for each transaction based on the terms and conditions agreed upon by the parties.read more on company’s behalf and charges a commission for its services.
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