F-405 | MFH | Chapter 7

Monitoring Accounts Receivable

How Granting Credit Sales Benefit the Seller:
 Credit terms encourage buyers to buy more. They can even become addicting for the customer so
much that they may make unnecessary purchases. In other words, the sellers try to break customers’ self-
control through the credit terms.
 Credit terms attract new customers. If the credit terms of one seller become more lenient than others,
it may attract the customers of the other sellers. In this way, the sales are increased. But it may also
increase bad debt. (Also, according to game theory, at some point the credit terms will become the same.)

WHY MONITOR ACCOUNTS RECEIVABLE?

Accounts Receivables result from CREDIT SALES. A firm is required to allow its customers credit to expand its
sales volume. Receivables contribute a significant portion of current assets.

But for investment in receivables, the firms incur certain costs (opportunity cost)

Further, there is a higher risk of BAD DEBTS It is, therefore, very necessary to have proper control and
management of receivables.

The Accounts Receivable policies are made and implemented by firms based on their expectations regarding the
turnover of this asset and the amount of bad debt resulting from it.

 If these expectations are not fulfilled, this is a signal to management that the assumptions used in making
the firm’s terms-of-sale and credit-granting policies may be faulty, or
 Those policies are not being implemented properly. Deviations from the expected levels of turnover and
of bad debt can signal different problems.

Three problems relating to these policies are:

1. Changing Customer Payment Characteristics
2. Inaccurate Policy Forecasts
3. Improper Policy Implementation

The monitoring process is a comparison of expectations and outcomes.

Monitoring provides signals of deviations from expectations.

When a signal is detected, it is expected that managers investigate and assess the reason for deviation.

The managers must then take the necessary corrective action

The type of necessary action will vary with the cause of the deviation

Account for Uncollectible Accounts (Bad Debts)

Selling on credit provides both a benefit and a cost:

 The benefit = selling to a wide range of customers

 The cost = unable to collect from some customers, chasing payment from some customers

Uncollectable accounts create a cost or expense called bad-debt expense, uncollectible-account expense, or
doubtful account expense.
Bad debt expense is an operating expense:

 Decreases net income

 Decreases net accounts receivable

Estimating Uncollectible
1. Percentage-of-Sales Method
2. Percent-of-Accounts-Receivable Method
3. Aging-of-Accounts-Receivable Method

All three approaches work under the allowance method, and all require an adjusting entry at the end of the
period.

1. Percent-of-Sales Method
Computes bad debt expense as a percent of net credit sales. It is based on prior experience of the business

For example:

Based on prior experience, the bad expense is 2 percent of net credit sales; credit sales were $500,000

2. Percent-of-Accounts-Receivable Method
The allowance is based on a percentage of the total accounts receivable outstanding

Assume that the outstanding accounts receivable is $100,000 and 5% is estimated to be uncollectible.

These two are derived from prior experiences with the customers, or information from peers’ experience (if the
business is new).

3. Aging-of-Accounts-Receivable Method
This portion is discussed in the later part of this note. Do not forget to write this in the exam if question
comes regarding estimating collectibles.

Tools for Monitoring Accounts Receivable

A firm can use several financial ratios as effective tools for monitoring the Account's receivables.

Followings are some of the common tools are:

1. Receivable Turnover Ratio

2. Days’ sales outstanding (DSO)
3. Aging fraction schedule

Evaluating the Level of Accounts Receivable

 How many times, on average, does a company turn its receivables into cash during an accounting period? →
Receivable Turnover
 How long, on average, does it take a company to collect its accounts receivables? → Days’ Sales outstanding
or Uncollected

1. Receivable Turnover
How quickly RECEIVABLES are CONVERTED into CASH.

It reflects the relative size of a company’s accounts receivable and the success of its credit and collection policies
 2. Days’ Sales Outstanding
Day's sales outstanding (DSO) is a measure of the average number of days that it takes a company to collect
payment after a sale has been made. DSO is often determined on a monthly, quarterly, or annual basis.

3. Aging-of-Accounts-Receivable Method
Aging schedule: is a table that shows a summarized breakup of Accounts-Receivable into different time brackets.
Individual accounts receivable from specific customers are analyzed according to the length of time they have
been outstanding. The probability that the longer a bill is unpaid, the less likely it will ever be paid.

তাহমিদের কাদে ৩ জন ক্রেতা আদে, সাে, আপন, সাকুইব। সােদক ও একটা িাল মবমে করদে ২০ হাজার টাকার, ৩০ মেন আদে এখদনা
টাকা ক্রেয় নাই। তাহমিদের মহসাদব এরকি ক্রেগুলা ১-৩০ মেন আটকাই রাদখ ওদের িদযে ১% মিফল্ট কদর। আপদনর কাদে ২ বার িাল
মবমে করমেল, ক্রেগুলার টাকা পায় নাই। ৩৫ মেন আদে, আর ৭০ মেন আদে। তাহমিদের মহসাদব এরকি ক্রেগুলা ৩১-৪০ মেন আটকাই রাদখ
ওদের িদযে ২% িাদলর টাকা পাওয়া োয় না, আর ক্রেগুলা ৬১-৯০ মেন আটকাই রাদখ ওদের িদযে ৫% মিফল্ট কদর। আর ও সাকুইদবর
কাদে ১০০ মেন আদে একটা িাল ক্রবচমেল। তাহমিদের যারণা ৯০+ মেন যদর টাকা না মেদল যরা োয় ক্রে ৯০% সম্ভাবনা আদে ক্রে অইটার
টাকা আর পাদব না। এই ক্রে তাহমিে পাওনাগুলাদক কতমেদনর আদের ক্রস মহসাদব একটা গ্রুদপর িদযে ক্রফদল ক্রফদল পাওয়ার সম্ভাবনা কতটুকু
ক্রসটা যারণা করদতদে, এটাই সাদয়ন্স, থু ক্কু Aging of A/R।

It is an important tool used in working capital management to project patterns of collections and estimate
doubtful debt.

Aging-of-Accounts Receivable Method, Example

Customer Name 1-30 Days 31-60 Days 61-90 Days 90+ Days Total Balance
Baring Tools Co. 20,000 20,000
Calgary Pneumatic Parts Ltd. 10,000 10,000
Red Deer Pipe Corp. 3,000 5,000 8,000
Seal Coatings Inc. 9,000 1,000 10,000
Other Accounts * 30,000 2,000 12,000 8,000 52,000
Totals (a) 60,000 5,000 26,000 9,000 100,000 (1)
Estimated percent uncollectable (b) 1% 2% 5% 90%
Allowance for Doubtful Accounts [(a)*(b)] 600 100 1300 8100 10,100 (2)
*Each of the other accounts would appear
individually
(1) Accounts Receivable
(2) Allowance for uncollectable accounts

BIAS in Simple Measure of Receivables Turnover (Problem of all three methods)

Assume that a firm makes 5% of sales for cash. 65% of a month’s sales are paid in the next month, 25 % in the
second month following, and the remaining 5 % in the third month following the sale.

This pattern of customer payment does not vary over the year, but monthly sales volume is seasonal.

The firm experiences constant sales volumes of $5 million per month from November through March; sales then
increase through April to a seasonal peak of $9 million per month in May, then decrease to a low of $1 million
per month in September, finally climbing back to $5 million a month in November.

The important thing to remember is that, by assumption, the payment habits of customers are the same
throughout the year: customers pay on an average 39.0* days. Sales average $5 million per month, and there is
no overall trend in sales except for seasonality.
 Sales Pattern (M)
Cash Sales 5% Nov-Mar 5,000
Coll. First Month Prior Mo. 65% May (peak)9,000
Coll. Second Month Prior Mo. 25% Sept (fall) 1,000
Coll. Third Month Prior Mo. 5%

Month Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan
Sales 5,000 5,000 5,000 7,000 9,000 7,000 5,000 3,000 1,000 3,000 5,000 5,000 5,000

Out. Current Month 4750 4750 4750 6650 8550 6650 4750 2850 950 2850 4750 4750 4750
Out First Prior Mo. 1500 1500 1500 2100 2700 2100 1500 900 300 900 1500 1500
Out Second Prior Mo 250 250 250 350 450 350 250 150 50 150 250
Receivables Oustanding 6500 8400 10900 9700 7300 4700 2100 3300 5700 6400 6500

DSO (2-Month Average) 39.00 42.00 40.88 36.38 36.50 35.25 31.50 49.50 42.75 38.40 39.00
Actual Collection Rate 39.00 39.00 39.00 39.00 39.00 39.00 39.00 39.00 39.00 39.00 39.00
Over or (Under) 0.00 3.00 1.88 -2.63 -2.50 -3.75 -7.50 10.50 3.75 -0.60 0.00
The link and QR Code to the Excel file is given at the end.

The day’s sales outstanding (DSO) statistic is interpreted as the average number of days of sales that are still
owed at the end of the month being evaluated. It is computed as:

DSO = (month end receivables/average sales) * (30 days /month)

DSO, Aging Fraction Results Compared

Month Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan
DSO (2-Month Average) 39.00 42.00 40.88 36.38 36.50 35.25 31.50 49.50 42.75 38.40 39.00
Aging Fractions
0-30 Days old 0.73 0.79 0.78 0.69 0.65 0.61 0.45 0.86 0.83 0.74 0.73
31-60 Days old 0.23 0.18 0.19 0.28 0.29 0.32 0.43 0.09 0.16 0.23 0.23
61-90 Days old 0.04 0.03 0.02 0.04 0.06 0.07 0.12 0.05 0.01 0.02 0.04

The DSO results of September show average collection period jumped from 31.5 days to almost 50 days in
October, while Aging fraction data shows, in September, the average outstanding within 30 days range dropped
to only 45%, while it soared to as high as 43% for 60 days range in September. However, in October, Aging
fraction results show within the 30-day range outstanding again jumped to 86%. Although the DSO results show
that the average collection period jumped to almost 50 days. These results indicate some contradicting results.
Further, as the two models assume, the customer payment behavior is the same, but the data does not
support the same.

Problems associated with DSO and Aging Schedule

The Aging Schedule may show distorting results even though customers maintain the same payment pattern each
month. Both Aging Schedule and DSO measures are biased when sales fluctuate over time:

 they may show deviation from expectation when no change has occurred and
 may not signal a deviation when one has occurred.

Therefore, both these measures may give inappropriate signals.

DSO and aging schedule will provide proper signals of receivable movement only when there is no sales
fluctuation over time.

Better Tools for Monitoring Accounts Receivable

Three appropriate tools can be used that are not subject to distortions caused by sales fluctuations:

1. The ratios of receivables outstanding to original sales,

2. Customer’s payment proportions, and
 3. The sales-weighted DSO.

Financing Receivables
Money tied up in receivables is something that many companies seek to avoid. Companies may use one or more
of these methods so that they can receive cash faster:

Set up a separate Borrow money Factor

finance company and pledge A/R A/R
Sale or transfer of A/R;
Ford Ford Motor Credit Company
In case of default on the buyer may bear risk
loan, A/R (collateral) of collection (factoring
GM General Motors Acceptamce Corp. can be taken and without recourse) or the
converted to cash seller may bear
to satisfy the loan risk of collection
Sears Sears Roebuck Acceptance Corp.
(factoring with recourse)

Factoring
Factoring is a unique financial innovation. It is a method of converting non-productive assets (i.e receivables)
into productive assets (i.e. cash) by selling receivables to a company that specializes in their collection and
administration.

Factoring is a popular mechanism for managing, financing, and collecting receivables.

A factor (financial institution) purchases the client’s A/R and makes the conversion of receivables into cash
possible.

Factoring services
 A factor provides full Credit administration services to its clients.
 Credit collection and protection services
 Financial assistance- extending cash advance against book debt

How Factoring Works

Cost of factoring:
• The factoring commission and service fee
• The interest on advance granted by the factor to the firm
Types of Factoring
• Advance Factoring/Maturity Factoring
o Full-Service Non-recourse Factoring
o Full-Service Recourse Factoring
• Bulk/Agency Factoring
• Non-notification Factoring

 Full-service nonrecourse:
• Under this method, book debts are purchased by a factor, assuming 100% credit risk.
• The factor takes on all the risk of uncollectible receivables. The company that transferred receivables has no
liability for uncollectible receivables.
• The factor advances 80-90 % of the book debts immediately to the client
• Customers are required to pay directly to the factor
• Factor maintains the sales ledger and amounts and
• prepares age-wise reports of outstanding book debt.

 Full-service recourse factoring:

• Under this method, the client is not protected against the risk of bad debt.
• The client will have to refund the money if any customer defaults to pay to the factors for which the factor
has advanced funds against book debts.

 Bulk/ Agency factoring:

Under this method, client continues to administer credit and operate the sale ledger. The factor finances the book
debts against bulk either on recourse or without recourse.

 Non-notification factoring:
Customers are not informed about the factoring agreement. Factor keeps the A/C ledger in the name of a sales
company to which the client sales his/her book debt.

Excel Link: https://docs.google.com/spreadsheets/d/1-n_4UC-

l5PZOZjkwxeYTiRUw_pfqhGXg/edit?usp=drive_link&ouid=109421102839035998571&rtpof=true&sd=true

Special Thanks to MRH