Collections

Updated on April 4, 2024
Article byShrestha Ghosal
Edited byShrestha Ghosal
Reviewed byDheeraj Vaidya, CFA, FRM

Collections Definition 

Collections is the process through which businesses receive payments from customers or clients for the goods sold or the services offered. This process helps companies maintain a positive cash flow, decrease bad debts, and boost their profitability. It plays a vital role in maintaining a company’s financial health.

Collections

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Collections (wallstreetmojo.com)

The collections process includes sending invoices to the customers and following up on unpaid invoices through reminders or phone calls. Additionally, it involves negotiating the payment terms and recording received payments in the accounting system. It comprises all the activities required to ensure the business gets its outstanding payments on time.

Key Takeaways

  • Collections in accounting are methods for businesses to collect outstanding payments from customers and clients in exchange for the goods and services they provide. 
  • It involves tracking and maintaining the account receivables to identify overdue payments and take prompt corrective actions if necessary.
  • Effective collections procedures help businesses maintain a positive cash flow, improve financial ratios and maximize profitability.
  • Furthermore, this process is crucial in enhancing a company’s financial position and boosting its financial stability.

Collections In Accounting Explained 

Collections in accounting is the process of monitoring and receiving outstanding payments from customers or clients by a company for the goods or services exchanged. It includes tracking and maintaining the overdue accounts receivables to ensure the debtor pays off the payments on time. This process plays a significant role in maintaining a steady cash flow and overall financial stability for a company.

Successful collections procedures are necessary for businesses to decrease the threats of bad debts and boost their financial operations. It involves a systematic approach to tracking and handling outstanding debt, communicating with clients and customers, and engaging effective strategies to obtain overdue payments. 

Accounting for Financial Analyst (16+ Hours Video Series)

–>> p.s. – Want to take your financial analysis to the next level? Consider our “Accounting for Financial Analyst” course, featuring in-depth case studies of McDonald’s and Colgate, and over 16 hours of video tutorials. Sharpen your skills and gain valuable insights to make smarter investment decisions.

Procedure 

The collections procedure is as follows:

  • The process starts with generating and sending invoices to the customers that mention the amount owed, payment terms, and the due date. It helps customers by offering a clear picture of their payment obligations.
  • Companies must monitor the aging of accounts receivable regularly to recognize any overdue payments. It includes tracking the outstanding invoices and their due dates.
  • When an invoice becomes overdue, businesses must contact the customers.
  • If a customer fails to respond or delays payment, businesses may need to strengthen their collection efforts. They can do it through follow-up phone calls to address any concerns, negotiate payment plans, and offer rebates or incentives for early payment.
  • Businesses may evaluate a customer’s creditworthiness before extending the payment’s due date. They may review the customer’s credit history, credit score, or other relevant factors to identify credit limits and reduce non-payment risk.
  • Received payments must be recorded and applied to the corresponding customer accounts in the accounting system.
  • Businesses may regularly reconcile accounts receivable balances with payment records to determine discrepancies and take timely corrective actions if required.

Examples 

Let us discuss a few examples:

Example #1

Suppose Daily Forever is a small retail store selling goods to customers on credit. After a month, the store sent invoices to each customer containing all the details about the amount due and the payment deadline. Kylie, a customer, had an outstanding invoice that amounted to $1000 that was past the due date.

Daily Forever sent a gentle reminder to Kylie via email stating that her payment was overdue and requested a prompt settlement. However, Kylie did not respond to the mail or make the payment within the specified period.

The store decided to make a follow-up phone call to Kylie. They asked her why the delayed payment was delayed and tried to resolve her issues or concerns. Kylie informed them she was out of the station, and they revised the payment date. Furthermore, she repaid the outstanding $1000 to Daily Forever on the revised due date. The store reported the received amount in their financial records. This is an example of a collection.

Example #2

Businesses are increasing their efforts to collect their debts and bring in cash to reduce future write-offs before a potential downturn.

The finance directors started focusing more on working capital, with the Federal Reserve increasing the interest rates over the past year. The chief financial officers aimed to increase cash flow, reduce outstanding debts, and increase deposits in higher-yielding bank accounts. They are concentrating on their accounts receivable to improve their chances of collecting the money their customers and clients owe them if the economy enters a recession in 2023.

As a result, businesses are encouraging their customers and clients to pay their bills on time by offering rebates for early payment or negotiating shorter billing cycles, according to advisors.

Collections vs Charge Off vs Receivables 

The differences are as follows:

  • Collections: It is the process where a business pursues and obtains from customers or clients who have unpaid invoices and outstanding debts. It includes sending reminders to the debtors, contacting them through phone calls or emails, negotiating the payment terms, and recording the received payments. It aims to recover the outstanding debts and maintain a steady cash flow.
  • Charge-off: It happens when a creditor recognizes that a debt is unlikely to be collected and removes it from their books as a loss. Usually, creditors do it after a certain period of delinquency, like 180 days. It signifies that the creditor has given up on collecting the debt. However, it does not remove the debtor’s obligation to repay the outstanding amount.
  • Receivables: The amount that the customers and clients owe to a business for the goods and services exchanged is known as receivables. They display the company’s outstanding accounts receivable and are treated as assets on the balance sheet until the debtors repay them.

Frequently Asked Questions (FAQs)

1. How do collections impact financial statements? 

This process affects the financial statements by boosting the cash flow and accounts receivables. The accounts receivable amount reduces on receiving the outstanding payments, positively impacting the balance sheet. Moreover, it increases the cash flow, which enhances the liquidity and, in turn, augments the financial ratios.

2. What is the role of credit policies in collections? 

Credit policies play a significant role in this process by setting up guidelines for granting credit facilities to customers, establishing credit limits, and determining payment terms. Effective credit policies help minimize the threats associated with late payments and non-payment. Furthermore, they support and enhance successful methods.

3. What is the impact of collections on cash flow? 

This accounting process has a crucial impact on the cash flow. When companies receive payments from customers and clients, the amount the company receives directly impacts the cash flow. Furthermore, successful methods allow a steady cash inflow which assists in meeting the company’s financial requirements like supporting business operations and paying for various expenses.

4. How can businesses handle disputes or discrepancies related to collections? 

Companies should promptly address customer or client issues when they encounter any dispute or discrepancy related to the process. They must probe into the matter and provide clear proof of documents related to the outstanding debt. Additionally, companies must effectively communicate and negotiate with customers to find an appropriate solution.

This has been a guide to Collections in accounting & its definition. We compare it with charge off and receivables, explain how to remove it from credit report, & examples. You can learn more about it from the following articles –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *