T102 Accounts Receivable

Finance & Accounts Training Training for Accounts Receivables

Infosys BPO Ltd., Bangalore

Finance Center of Excellence

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Table of Contents

Accounts Receivable What is Accounts Receivable (AR)? .............................................................................................................. 5 What is AR Department? .............................................................................................................................. 5 What is accounts receivable process? .......................................................................................................... 5 Step 1 - Receivables management: Pre-Invoicing Engagement................................................................ 6 Credit policy .......................................................................................................................................... 6 Credit Review Process ........................................................................................................................... 8 Assessing the ability to pay ....................................................................................................................................... 8 Assessing the ability to pay on time .......................................................................................................................... 9 Assessment of willingness to pay.............................................................................................................................. 9 Parity in dealing with small/large suppliers .............................................................................................................. 9

Credit Review Scorecard ....................................................................................................................... 9 Credit Limit .......................................................................................................................................... 10 Determining commercial terms .......................................................................................................... 10 Credit Terms ........................................................................................................................................................... 10

Types of Discount and Allowances...................................................................................................... 12 Periodic Credit Term Review............................................................................................................... 13 Sales Order (SO) .................................................................................................................................. 13 Hold Activating/Releasing Holds ......................................................................................................... 13 Setting up a New Customer Account .................................................................................................. 14 Step 2: Receivable Management-Post Invoicing Engagement ............................................................... 14 Collection Follow-up ........................................................................................................................... 14 Customer escalation matrix .................................................................................................................. 1 Importance of invoicing ...................................................................................................................... 16 Recovery from a new customer .......................................................................................................... 17 Customer Query Resolution ................................................................................................................ 17 Supplying Documents ......................................................................................................................... 17 Case History Update............................................................................................................................ 18 Cash Monitoring/Cash Forecasting ..................................................................................................... 18 Provision for Bad & Doubtful Debts .................................................................................................... 19

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Percentage of Sale method ...................................................................................................................................... 20 Aging Method ......................................................................................................................................................... 20 Writing off the bad debt .......................................................................................................................................... 20

Claims Creation/Claims Resolution ..................................................................................................... 20 Cash Application.................................................................................................................................. 21 Tolerance Limit.................................................................................................................................... 22 Charging of Interest ............................................................................................................................ 23 Dealing with Defaulters....................................................................................................................... 23 Factoring ............................................................................................................................................. 23 Customer Account Reconciliation ....................................................................................................... 23 Receivables Review ............................................................................................................................. 24 Sub ledger- General ledger reconciliation .......................................................................................... 24 Recommended metrics for AR process:.................................................................................................. 24 AR process metrics:................................................................................................................................. 24 Other Metrics: ......................................................................................................................................... 25 AR business metrics: ............................................................................................................................... 25 Key Risk Indicators in AR Process:........................................................................................................... 26 Other Important terms to know ............................................................................................................. 26 Self-Study Questions ................................................................................................................................... 28 Glossary ....................................................................................................................................................... 29

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What is Accounts Receivable (AR)? Selling Goods and Services to the customers is one of the regular features of running the businesses. Companies provide their customers sometimes the facility of not paying immediately the due at the time of transaction to the supplier. Instead customers receive credit from the supplier. This credit transaction results in money being owed by the customer to the company. This money due from customers is called Accounts Receivable. ARs are the type of current assets for the company and will be recorded in the Balance Sheet along with other current assets of the company. In simple terms, Accounts Receivable is money due from customers against the goods sold to them on credit or services rendered on credit.

What is AR Department? A business organization which has given the credit to its customers has to collect the same from them within a specified period. Accounts receivable department in most companies will take care of this activity. AR department does the credit review of prospective customers collects the money from the customers applies the cash once it is received from the customers manages the bad and doubtful debts

What is accounts receivable process? The accounts receivable process is a part of “Quote to Cash cycle” (or Q to C cycle). The quote to cash cycle starts when the companies give quotation to the prospective customer and ends once the final payment is made by the customer.

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Receivables Management New Customer Credit Terms

Order Release

Pre Invoicing /

INV

Collection Follow-up

New Cust. Credit Hold/

Customer Query Resolution

ORDER TO Reconci PO REMITTANCE

RM

Faxing Docs. E.g. Invoice copy, POD

liation Receivables Review

Turning Defaulters into Legal

Post Invoicing (Invoice to Cash)

Cash Application Claims Creation / Resolution

Consistent Monitoring of incoming cash

Objectives of Accounts receivable (AR) process: a. b. c. d.

Reduce order to cash cycle times Reduce operational expenses Reduce revenue leakages and charge backs Accelerate cash flow by reducing DSO and write-offs

Step 1 - Receivables management: Pre-Invoicing Engagement Credit policy Credit policy is the basis or criteria for determining whether or not credit should be allowed to a customer. The policy also gives guidelines for deciding on the Credit period allowable and the credit limit in terms of amount of credit. These issues normally consider the creditworthiness and financial strengths of the prospective customer and accordingly decide as to what amount and for which period the credit can be offered.

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Every company will have different credit policy which is tailored to its needs. A sound credit policy

shall always be a reflection of the company’s needs for which these terms and conditions are designed. However, companies can take different stances while formulating the credit policy. The stances can be typically classified as: 1. Restrictive: To use this credit policy company should be invariably on a solid financial footing. The company is unwilling to take risks that are more than minor, preferring to do the business with the customer whose paying habits almost never vary from within terms. 2. Moderate: Also known as “middle-of-the road” credit policy. The moderate credit policy mixes good accounts with the average accounts that are always slow in payment. It is a more conventional mix of credit risks than the conservative or the liberal approaches to credit. There is comparatively a low risk involved in this policy compared to the restrictive policy. Some bank support is usually combined with monthly receivables collection to provide an adequate flow of cash. 3. Liberal: This type of policy reflects the high amount of risk thereby treated to be the most dangerous amongst the all credit policies. If the company follows liberal credit policy, the loss of receivables dollars can be heavy unlike the preceding two credit policies. Many companies who have a liberal credit policy are big risk takers in every area of their operation. The companies who design such policies shall always require a strong cash flow or financial backup otherwise it can’t opt for a liberal credit policy. Companies which follows the liberal credit policy allows the credit to the customers who are very slow in payment and normally pay within 40 to 60 days from the date of transaction.

The other factors that affect the credit policy of the company are described as under: 1. Relative bargaining power of a company vis-a-vis its customers- Bargaining power is a function of relative size of the trading partners, product differentiation, and relative importance of the product being purchased to the buyers business. If the company enjoys monopoly over the customer then the credit policy it would choose may be restrictive one, if it is other way round, means if the customer enjoys the monopoly over the company then company can go for either moderate or liberal credit policy as per its convenience and depending on the customer psyche. 2. Cash flow position of the company- cash rich companies can opt to give more liberal credits as compared to a cash deficient company, hence can go for either moderate or liberal credit policy. But cash deficient company has to go for a restrictive credit policy. 3. Market strategies of the company-A company that wants to penetrate the market and increase the market share as a strategic move will be seen to give more liberal credit as compared to a less aggressively marketing company.

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The credit policy basically is a tradeoff between grabbing the business opportunities on hand and managing the risk on the other. It’s a tradeoff between risk and return. The principal risk return tradeoff says that potential return grows with proportion to the increased risk. Low level of risk is associated with low potential returns, whereas high level of risk is associated with high potential return. In other words, the risk-return tradeoff suggests that the money invested can deliver proportionately higher profits if the chances of producing losses are comparatively high. It must be remembered that the cornerstone of any credit policy should not be to cut losses but to enable growth. Credit Review Process When a new customer asks for the credit, companies carry out a review process. A company will structure the credit review based on the credit policy. The credit policy gives the complete guidance on how to carry out the credit review. If the new customer satisfies all the condition specified on the credit policy, he will be allowed the credit. The function of credit review is generally performed by the Receivable Management Team (RMT); however, in the big company, a separate credit function team headed by the credit manager performs this function. While doing the credit review of the prospective customers, the company assesses: 1. Ability of the customer to pay or the Financial Risk 2. Ability of the customer to pay without delay or the Timing Risk 3. There is also third element to be considered is the Willingness or intentions of the customers to Pay

The function of credit review is generally performed by the Receivable Management Team (RMT); however, if the organization is big, this function is performed by a separate credit function headed by the credit manager. Assessing the ability to pay Ability to pay is nothing but the borrower’s capability to meet the future debt obligation. It’s known as financial risk. The financial risk is measured by reviewing some ratios based on the customer’s financial statements and the auditor’s report. The ratios used for this purpose are mainly profitability ratios and coverage ratios which give an indication about the customer’s financial strength. The profitability ratio analysis includes Net Profit ratio, Gross Profit ratio, EPS (Earnings per Share), ROI (Return on Investment) etc and coverage ratio includes, Fixed charge cover, Debt service cover etc. To analyze the past performance of any company all / some of the ratios mentioned above can be used. At the same time while assessing the ability to pay we are talking about the future capability of the prospective customer to pay the due on time. So it is important to have a look even on the future

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performance. Since the financial position of a company represents the competency of its business to face the challenges of the competitive environment. Simultaneously the non financial data is used to assess company’s strategic environment and its strengths and weaknesses which help in predicting the financial performance of company in future. The tools like SWOT analysis, strategic industry analysis can be used while assessing the future performance. Ratings compiled through various market researches’ conducted or measured by different credit rating agencies like Dun & Bradstreet popularly known as D&B, Compustat (standard & poor), are also useful to access the ability to pay. These companies independently obtain financial data and base their rating on a number of parameters. They charge subscription for this service. Assessing the ability to pay on time Sometimes it is possible that some companies are able to pay but may not be able to pay on time. The judgment of this can be made by discussing the cash flow position of the company. The cash flow and liquidity ratios are the basic indicator to judge the ability to pay on time. To adjudge the Liquidity position of the company ratios like Current Ratio, Quick Ratio, and Debt Equity Ratio etc. can be used. In a company normally the cash flow differs from profit figures because of accruals. This can result in situations where profits have been earned but not received in cash terms. In such cases, the company may have the potential to pay but not possible for the company to make payments on time. The measurement of timing risk is also based upon the historical data of Days Payable Outstanding (DPO) of that particular customer, and understanding the customer’s payment process including the documentation requirement to get payment. A cumbersome process could imply the inability to pay on time. Assessment of willingness and compliance to pay The willingness and compliance to pay can be assessed by trade references and keeping a record of the customer’s history of dealing with the firm. The job of getting trade references calls for tremendous maturity. For this it is essential to carry out the process in the proper spirit and confidentiality is required otherwise no one would be willing to give an unfavorable reference. The references received are as good as the collective maturity of the players in the industry. Parity in dealing with small/large suppliers Sometimes, it can be seen that customers deal differently with different categories of vendors. For instance, powerful vendors may be paid on time while smaller vendors are made to wait. While taking the credit references care should be taken that the references are being taken from vendors who have similar profile as the vendor seeking the references. Otherwise it becomes unfair. At the end of the credit review process the company will fix up the credit limit for the customer. Credit Review Scorecard Some organization uses a scorecard to review the credit worthiness of a prospective/existing customer. This scorecard indicates a suggested credit limit based on parameters like turnover, assets and capital,

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reputation of company and its promoters, growth prospects of the industry etc. and also on financial parameters like Growth, Profitability, Liquidity, Debt Exposure, working capital efficiency, cash flow status and Audit Qualification etc. The score card can also include references and credit ratings. Appropriate weights can be assigned to the various parameters. Credit Limit Through the credit review process, companies will decide the credit limit. It includes:
Credit Period: It is the duration (in days/months) allowed to the customer for granting credit.
Credit Amount: This is the maximum limit of amount for credit can be allowed to a customer. For example, if a customer carries a credit limit of $ 50,000, we can continue to make credit sale to that customer as long as the total outstanding credit to him does not exceed that amount.

Determining commercial terms

After the decision is taken on extent and duration of credit to the customer, these credit terms need to be articulated in commercial terms. It is good to have an understanding of these terms. Credit Terms 1. Open Credit: This is the most popular credit term in the market. This means that dues would be paid by the customer after a specified duration. This duration includes the period from the date of the invoice or from the date of the delivery of goods. The credit term is expressed using the term “Net +No. of days”. For example if open credit is shown as “Net 30”, it means the customer is liable to pay within/up to 30 days from the date of the invoice of the vendor. Note open credit does not mean that the credit term is open or infinite- there is a definite duration if time within which the customer needs to pay his dues.

2. Partial Prepayment & Partial Credit: Sometimes, a partial prepayment and partial credit is agreed between parties in a transaction. The ratio could be something like 25:75, 50:50, 75:25 etc. If we consider credit term of 25:75, it means 25% of the invoice amount needs to be prepaid and the remaining 75% is on credit.

3. Payment upon Delivery: In this case, the customer has to pay the dues on the invoice as soon as the goods are delivered to him as per agreed terms.

4. Sight Draft: Generally, goods are dispatched through a third party transporter. The transporter requires proof from the customer that the goods are intended to be delivered to him. Generally, shipping documents are used as a proof for this purpose. The supplier sends a copy of the shipping documents (e.g. invoice/ bill of lading/ packing slip/ insurance documents) to the customer by courier and these are used as proof for delivery.

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In case a sight draft is used, the supplier does not send the shipping documents directly to the customer but sends them to the customer’s bank along with the sight draft. The bank releases the documents to the customer soon after he makes the payment against the draft. After this, the customer is entitled to take the delivery of the goods. This can also be taken as a bill of exchange payable when presented. This arrangement is used when the seller wants to retain control over the goods that are being shipped to the customer. 5. Time Draft: A time draft is similar to a sight draft with one major difference. In this case too, the supplier sends shipping documents to the customer’s bank; but in this case the customer accepts the draft by writing “ACCEPTED” on the draft. The bank releases the shipping documents after the draft is accepted. The Payment will be received by the bank on due date as per terms mentioned in the draft. 6. Letter of Credit (LC): basically the letter of credit is a document issued by a bank giving guarantee for a client's ability to pay for goods or services. A bank issues letter of credit on behalf of buyer to the seller. When the seller presents documents comprising for complying with the terms and conditions in the LC before the issuing bank, within the expiry date of the LC, the issuing bank is obliged to honor the same irrespective of any instructions made by the applicant to the contrary. This can also be known as the obligation to honor (payment) and shifting from the applicant to the issuing bank. Typically the documents requested in a Letter of Credit are the following: Invoice Packing slip Transporting the documents like a Bill of lading or Airway bill Insurance document Inspection Certificate Certificate of Origin The LC could be 'irrevocable' or 'revocable'. Any changes to the irrevocable LC are not possible without taking the consent of all the parties involved, i.e., the seller, the buyer and the issuing bank. In a revocable LC, changes can be made without the consent of the beneficiary. 7. Bank Guarantee: In this case, the customer’s bank issues a guarantee to the supplier stating that- if the customer does not pay to the supplier, the bank will make the payment. The bank becomes liable only in the case when the customer fails to pay and the seller invokes the guarantee. 8. Prepayment/Cash in Advance: This is the most secured credit term wherein the customer is supposed to pay in advance i.e. before receiving the goods or services. This payment term is possible only if the seller enjoys greater power than the buyer by virtue of size, monopoly etc.

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Types of Discount and Allowances

In order to push the customer to make the payment on all the outstanding invoices, companies allow different types of discounts and allowances. These are intended to speedup payments and provide comfortable liquidity to the firm. Sometimes they can also be used as a promotional device. Along with the credit terms the discount terms are also negotiated and agreed upon with the customers. There are different types of discounts and allowances that the company can offer to its customers. Companies offer various types of discounts to customers. Early Pay Discount If a company needs for immediate cash it can offer a cash discount to suppliers who might pay before the due date. This helps the company to manage its cash flows. Payment terms mentioned on the invoice specify whether an early pay discount is applicable, and if yes, the rate thereof. In case of early pay discount, the credit terms would read like “2/10 Net 30”. This term means that if customer pays against an invoice having a credit period of 30 days within 10 days, a 2% early payment discount would be allowed on invoice value. Quantity Discount These are the price reductions given for purchase of large quantities. Generally there are two types of quantity discounts: Cumulative quantity discount: These are price reductions based on the total quantity purchased over a set period of time. Non cumulative quantity discount: These are price reduction based on the quantity of a single order. Seasonal Discount These are the price reduction given to the customer who purchases goods or service during a slack period or off season. For example order for a winter clothes during summer season. Rebate These are normally the price reduction given to the customer as a part of a scheme generally after the sale happens. This will be paid by way of making an adjustment as reduction in the price, return, or refund of the amount already paid or contributed. This is also a type of sales promotion techniques.

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Periodic Credit Term Review Once a customer’s credit terms are determined, the same are periodically reviewed and may be upgraded or down-graded based on some factors like:
Payment performance of the customer is either well within acceptable standards or not acceptable
Financial strength of the customer has either improved significantly or has deteriorated significantly
Customer has requested enhancement of credit terms/credit limit in anticipation of increase in business volume
Customer is a subsidiary company for which the parent company, which has reasonably strong financial strength, stands as guarantor
Industry the customer belongs to is experiencing a major upturn/downturn Any revision in the credit terms should be posted into the system to facilitate order acceptance based on revised terms.

Once the credit review process gets over, the credit limit details are communicates to the customer by company. Negotiations for terms and conditions can be done, if the same is desired by the customer considering the credit policy and guidelines. The purchase orders can be forward only once the customer agrees with the same. If the received purchase order is correct in all the respect, the company will raise an internal document to initiate the sale which is known as a sales order. Sales Order (SO) Sales order is a seller generated document that authorizes the sale of specified items. It is issued after the receipt of a customer’s purchase order. The SO is an internal document generated within the company. The SO will be used to initiate the production/dispatch process as per the Purchase order/sales Order terms. Sales order will also show the details about the address of the customer where the goods are to be shipped along with the Purchase Order number reference, item description, tax details, shipping details etc. Hold Activating/Releasing Holds A hold is an instruction under which credit sale to a particular customer is stopped till the hold is released. The types of hold can be: • Credit hold • Past due hold • Manufacturing hold

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Credit hold is put when the credit availed by the customer after the proposed sale would exceed his credit limit. Credit hold would be released after the customer pays against some old invoices thereby releasing his credit limit or is his credit limit is enhanced after a credit review or the credit manager makes a special sanction. The last option of a special sanction should be used only in exceptional cases. Past due hold is a hold on customers who have not paid some past invoices on due dates. A past due hold would be released after all outstanding payments are received from that customer. A manufacturing hold is put when the items required by the customer are not available from the factory. Setting up a New Customer Account When a new customer is added, his account needs to be set up in the database with all necessary details including address, contacts, credit terms, discounts, penalties and tolerances limits.

Step 2: Receivable Management-Post Invoicing Engagement After setting a new customer account in the database, credit sale will be made to the customer depending on its credit period and credit limit. The different modes through which a customer can make payment are – Check, Wire Transfer, ACH and Direct Deposit.

After the credit sale to the customer subsequent step would be to know about how to deal with the money received from the customer. The post AR sub processes includes cash application in which money received from customer is appropriately accounted for and collection which ensures collection from the customer as per agreed terms. Collection Follow-up Along with dispatching goods the invoice will be sent to the customers. After this, the company has to start the collection effort to collect the outstanding money from the customers. Some customers will make the payment without any collection efforts. But this percentage could be less. The company needs to design a proper and systematic collection strategy for the customers who do not make payment in time by themselves. There are numerous ways in which collection attempts can be made. Most frequent amongst them are phone calls to the customers and writing emails. In spite of these efforts, there will be customers, who do not pay due to financial or other reasons. Some customer could be absconding or could have filed bankruptcy. Such cases can be sublet to the external collection agencies or to the legal experts of the company as the case may be. Challenges in Collection

A customer can withhold payment for any small reason. Some of the examples are: 1. Order Related: Customer cancelled the order, but product was dispatched

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2. Product Related: Short/excess shipment, wrong shipment, damaged shipment 3. Service Related: Service billed not delivered/overbilling/ Service provided in part etc 4. Documentation Related: Invoice not matching PO/ POD required/ Tax Adjustments, missing/incomplete/incorrect PO number on Invoice 5. Installation Related: Product shipped but not installed at all or not installed completely 6. Billing Related: Wrong quantities billed, product returned – credit not issued

Apart from these reasons which require correction/rework, there are other reasons which also influence collections e.g.: 1. Not having appropriate customer contact information 2. Customer not responding to phone calls, emails or voice mails 3. Invoice dispatched not received by the customer/returned undelivered 4. Invoice did not reach the right party 5. Postal delay in delivery of invoice 6. Postal delay in delivery of check 7. Individual who availed the services moved out of organization without signing off the job 8. Customers software application is undergoing a transition 9. Customer shifted their operations from one location to another 10. Payment made by the customer has been misapplied; etc.

Ways to address these challenges

1. Keep the contact information of your customer (including escalation contacts) on a common database. 2. Send Reminders/Escalations in case of no response (Follow escalation matrix) 3. To avoid reworks this is needed to detect errors and corrections should happen at an early stage. 4. Don’t let your debt become too old: making collections from the older invoices is always tedious as compare to the fresh once, therefore, one shall try to collect payment as early as possible from all the open invoices. 5. Keep your high value customers in constant touch. 6. Build strong relationship with accounts payable on the other side. 7. Business on credit card takes away small margin, but ensures minimal bad debt. 8. You are required to be sure that you have authority or enough confidence to commit a particular thing before making any commitment to the customers.

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Customer escalation matrix

Collection efforts often begin through interactions with customer’s employees who are somewhere lower down in the customer’s organizational hierarchy. If it is found that this effort is not yielding positive results, it is necessary to escalate the issue to authorities higher up in the customer’s organization. It is a good practice to have in place an escalation matrix showing the organizational chart of the customer and the people to be contacted in case of escalation along with their contact details. Recovery an organization wide function

It is a preferred fact that whenever a customer finds any problem with any aspect of a supplier’s product / service offering, the reflex response of the customer is to hold back the payment. The underlying problem could arise in any part of the vendor’s organization. For instance, the problem could be in 1. 2. 3. 4.

R&D - Resulting in design defects Procurement - Bad quality of raw material hence defective product Manufacturing - Defects in product Accounts - Invoice errors.

Whenever a customer does not pay, this could actually be a pointer towards the root cause that lies somewhere deep in the organization. Many companies use customer complaints as triggers for improvement programs. People working in the collection teams are like eyes and ears for the organizations and asked to document all customer complaints in detail .Cross functional improvement teams are instituted to identify the root cause of the customer complaint. Thus, instead of approaching a complaint in a fire-fighting mode, it is better to address and resolve the root cause of the complaint. Importance of invoicing

Invoicing is an important step in receivables management. Any error in an invoice can immediately result in delayed payment. Examples of invoice errors 1. Wrong name- Can affect the VAT claim of the customer

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2. Sending invoice to wrong address3. Wrong tax code 4. Wrong freight charged

It should be ensured carefully that there are no errors left in an invoice. Recovery from a new customer

Special attention has to be paid while recovering money from a new customer. To avoid unnecessary delays in payments it is really beneficial to find out the procedure for making payments and adhering to those procedures while having transaction with the customers. Customer Query Resolution

In the course of business operation, while processing invoices, customers may have multiple queries such as:1. who is the end user of the product or service 2. queries related to product supplied 3. date of delivery etc. Responding to these queries facilitates prompt payment processing. In service industry, customers subscribe for a range of value added services, and they look for some clarifications on charges of such service, when they receive the invoice. There is a difference between a customer service query and a collection query. Whereas, customer service query is more about placing an order or enquiring about the present status, a collection query could be about the reasons for credit hold on the account. These queries can even be a request for confirmation of balances. Supplying Documents

Customers sometimes make requests for documents on an ad-hoc basis. These documents should be provided immediately, as delay in providing these documents could result in a potential bad debt. Invoice copy is the most sought document. Next in demand is Proof of Delivery (POD), PO copy etc. Customers’ instructions should be followed while forwarding these documents e.g. mode of supply i.e. printed copy, through email or through fax. Attention should also be paid to the name and addresses at which customer want these documents to be forwarded. In case a document has been requested to be sent through fax, it is always goods to reconfirm the fax number, if it is already available. After sending the requested document, an advisable approach is to confirm with the customer whether the document has been received by them, and then take a commitment for payment.

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Case History Update

It is important to keep a record of each and every event that takes place during collection attempts. The objectives of recording these events are multifold1. The case history helps collection analyst/reviewer to determine the next steps to be taken for collection based on the events already taken place. 2. The case history helps identifying the invoices that have disputes so that efforts could be made to resolve the dispute rather than contacting the customer again without resolution of the dispute. 3. The case history adds a lot of weight while escalating within customer’s organization. 4. The case history is a meaningful record that needs to be produced during the court of law to substantiate collection attempts. 5. The case history can be useful in reviewing credit limits of a customer. One’s own experience with a customer is any day superior to the reference made by a third party.

The approach should be to record all the important events on a particular account, or a particular invoice e.g. 1. 2. 3. 4. 5. 6.

Any query by customer and response thereof; Any request for document by the customer and compliance thereof; Any collection attempts, including email, phone call, voice mail etc. Any responses received from customer; Any dispute opened by the customer, and progress thereof; Any escalations done; etc.

Cash Monitoring/Cash Forecasting

Cash generated from sale proceeds is the prime source of cash inflow for any business. A collection analyst is the best positioned to estimate and quantify the potential collection along with the timing. The activities of cash monitoring and cash forecasting, form an important function in the entire receivables cycle. A number of reports and metrics are generated based on the potential cash inflow. Estimates are made on: 1. 2. 3. 4.

Collection expected from old dues; Collection expected from current dues; Collection expected from not due; and Collection expected from disputed items.

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Based on the potential cash collection, liquidity in the business is measured on various parameters: 1. Days Sales Outstanding (DSO): This is the average number of days for which money is blocked into the receivables of the company. This is the key indicator of liquidity strength of any business. Lower DSO indicates strong control on receivables process.

DSO is calculated as:

Average Trade Debtors X No. of Days Average credit Sale during a period

DSO can be calculated for company in totality or for an individual customers One drawback of using the DSO concept is that it is an average and may not highlight cases that have become sticky. Thus the company may fail to focus on old outstanding which need special collection efforts. DSO can also be represented in terms of turns. The number of turns made by receivables of a company is calculated as 365/ DSO. Thus if DSO is 90 days, the turns in receivables is approximately 4.

2. Past Due Percentage (PD %): Past due is that portion of total outstanding of a company which is already overdue. Nil value of Past Due indicates that all the customers pay well within their credit period; however, that is not a realistic scenario. Therefore, all attempts should be made to keep the PD% as low as possible. A realistic PD% will vary from industry to industry.

3. Aged Outstanding: Aged outstanding is that part of Past Due which has exceeded the allowable credit period in number of days since the time it became over due. This is indicates the quality of a receivable. More aged the outstanding, worse off is the quality of the outstanding. A company may use the concept of buckets to assess the age of debtors. Amounts due from debtors will be distributed in buckets such as 0 to 90 days, 90 to 180 days, 180 days +.

Provision for Bad & Doubtful Debts

If a company finds that it cannot recover the money from customers even after all efforts, it may have a policy to write off such debt based on the age of outstanding or actual case history. However, when we write off a debt, that debt is removed from the books which would mean no more efforts will be taken to recover that amount. So most companies take a phased approach towards this by retaining the debt in the books but create a liability called provision for bad and doubtful debts. The accounting entry passed is. Bad debts A/c Dr To Provision for bad debt A/c

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1. 2.

Percentage of Sale Method Aging Method

Percentage of Sale method Under this method, historical data is analyzed to find the relationship between bad debts and credit sale. An assumption is then made that the bad debts in the current year will bear in the same proportion to sale as in the historical data. The alternative to this is a use of bad debt ratio of another company in a similar business context. Example of the method Total Credit sale for the year $6,000,000 Bad debt ratio from previous year Computed year end provision for bad debts

1.25 % $ 75,000

Care should be taken to ensure that any changes in the business scenario that may impact the bad debt ratio should be factored in (E.g. a geographical area having large number of customers is facing an economic downturn). This could impact the ratio for the year.

Aging Method Under this method, the receivables will be classified by aging in days/ months outstanding. Based on the entities past experience, for each of the buckets the ratios of bad debts will be found and applied to this year’s figures. Example of method Age of accounts Under 30 Days Gross receivables $1,100,000 Bad Debt % 0.5% Provision required $5,500

30- 90 Days $425,000 2.5% $10,625

90 Days and above Total $360,000 15% $54,000 $70,125

Writing off the bad debt Subsequently, when the decision is taken to write off the debt, the debt will be removed book by adjusting against the provision account

from the

The accounting entry passed will be Provision for bad debt A/c Dr To Receivables A/c

Claims Creation/Claims Resolution One of the important areas in Receivables Management domain is Claims Creation and Claims Resolution.

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What is a claim? Claim with regard to receivables management is customer’s dispute on full or partial value of the invoice. The dispute could be on the product or service, price, quantity, discount, or taxes. Each claim raised by the customer is researched and validated before making any adjustment to the invoice. If it is found to be a genuine claim, it is generally settled with a credit note in the customer’s account. While researching and validating a claim, relevant documents generated in the course of the transaction are referred to and the case is evaluated based on the merits of the documents. There could be cases where some verbal commitments by sales to the customer have not been documented. In such instances, the case is referred to the concerned sales individual for further clarification. Once the claim is resolved, the customer should be informed about the same. From the control perspective, higher numbers of claims indicate lower level of control on errors. Therefore, organizations generally track and analyze claims for an indication of potential improvement area.

Cash Application

Cash application is an activity where payments received from customers are applied to their respective account. Every receipt must be applied against the invoice for which the payment is made. Generally, every receipt will be accompanied by a remittance advice / slip which will show the details of invoice against which the payment is received. In case such information is not avaialble, the money could be temporarily parked by applying it against the customer as an on account payment. If even the customer name is not known, the receipt will be kept in the suspense account. However, the missing details must be quickly obtained and the receipt must be applied against the invoice. Note an open invoice is an invoice against which no receipt has been applied. Why it is important to apply receipts correctly:

1. Customer’s account would not reflect a true picture unless application is done appropriately 2. A lot of time would be spent into rework i.e. reconciliation, tracing the money received and applying it 3. A huge amount of unapplied cash indicates poor control on the business 4. Un-reconciled accounts increase collection efforts

Approach for cash application, in the order of preference is:

1. Based on invoice number/s provided by the customer; 2. Based on PO number/s provided by the customer; 3. Based on the match of amount paid with value of open invoices

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4. Based on First In First Out (FIFO) approach 5. Apply payment as ‘On Account’ and set off against invoices later

If the receipt is applied in any manner other than against invoice number, the case should be researched and the receipt applied against an invoice as soon as possible. Challenges & Resolution:

1. Unidentified Receipts i.e. money credited into bank without adequate identification of the remitter or the invoice number – Action: Contact the bank and ask them to provide customer details. Such receipts will be credited to the suspense account and will be a liability for the company. 2. Invoice/PO Details not provided by the customer in the payment instrument– Contact the Customer and obtain details 3. Invoice/PO details provided in the remittance instrument are not correct – Contact the customer and reconfirm the details 4. Invoices mentioned in the remittance details are already closed i.e. they were either cancelled or were adjusted against some old remittance– Reconcile the account with the customer 5. Customer takes deduction and short pays i.e. customer deducts a portion of the invoice for money payable to him. Examples are unearned early pay discount (i.e. discount taken when it is not due), price discrepancy, quantity discrepancy, recovery of excess money paid earlier, tax and/or freight wrongly charge etc.– Verify the deduction and take approval to issue credit note 6. Excess payment from customer i.e. payment of more money than what is showing outstanding against a particular invoice – Contact the customer and verify details

Tolerance Limit

Often it will be found that a customer will pay short of the invoice amount. This can be due to many reasons. Sometimes customer will intentionally short pay as he will not agree for a particular charge put in the invoice. That’s why companies have to set tolerance limits. If payments are within the tolerance limits they will be accepted in full and final discharge of the invoice. It can be either set as a percentage on the total invoice value or a specific sum. Example: lover of 2% of invoice value or $100. Such a limit shall be set for each customer. The difference in the amount will be written off by way of issuing a credit note favoring customer. If it is found as a constant feature of the customer of paying short, his tolerance limit may be removed so that he will not be able to play with the system.

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Charging of Interest

Sometimes, companies charge customer with interest if payment is not received on time. This is done only if it is decided as per the terms of agreement. The interest is often waived after charging the customer since it is often used as a tool for negotiating in future with the customer to force an early payment. Dealing with Defaulters

In general meaning, defaulter is someone who fails to meet a financial obligation. However, here the meaning of defaulter is a customer, who either does not respond to collection attempts, or does not pay due to financial or other reasons. Customer may be absconding or may have filed bankruptcy. Such cases can be referred to an external collection agency or to the legal experts of the company depending on the track record of the customer or the background of the case. Collection agencies visit the customer and help colleting a potential bad debt. In consideration, they charge a percentage of the money collected by them. Legal experts work on strength and benefit of suing the customer and collect the dues through a legal case. Factoring

Companies may sometimes employ the services of factors to recover their dues. Factors purchase the receivables from the company at a discount and collect the money from the company’s customers. Factoring agreements could be with recourse or without recourse. In a “with recourse” factoring arrangement, the factor can collect the money from his client if he cannot recover the money from the client’s customers. In a “without recourse” factoring arrangement, the factor would have to bear the impact of unrecoverable items. Customer Account Reconciliation

Companies have practice to reconcile their large accounts periodically to avoid any difference in A/R balances between company’s books and customer’s books. In fact, the concerned analyst would request the customer to send their account statement. This reconciliation is also done when customer does not agree to the outstanding as per statement provided by the vendor. This reconciliation helps identifying items that cause difference, and addressing these items appropriately. The reasons for difference could be:

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1. Money paid by customer has not been received; 2. Money paid by the customer has been misapplied (i.e. applied against wrong account/wrong invoices) 3. Invoice raised by company has not been accounted by customer 4. Credit note/debit note raised on either side has not been accounted 5. Goods returned by customer have not been received or credit note has not been issued.

Receivables Review

In the receivables management cycle, it is important to prioritize collection efforts and focus on right set of accounts/invoices which can cover short term and long terms objective of the process. Basically the prioritization happens around coverage of number of invoices, value of invoices and value of old outstanding. A reasonable coverage on all these parameters helps controlling DSO, PD%, aged outstanding and provision for bad and doubtful debt. Sub ledger- General ledger reconciliation

Before accounts are closed, it is required to reconcile GL and the AR sub ledger. This activity is performed while doing general ledger accounting.

Recommended metrics for AR process: AR process metrics: Metrics

Sub-Process

Metrics definition

Measurement

Accuracy {fatal} = (1 – (No. of defective transactions/ No. of transactions audited)) * 100

Accuracy %

Sampling Plans Cash application / Dispute resolution / Collections

Accuracy {non-fatal} = (1 – (No. of defective transactions / No. of transactions audited)) * 100

Remarks The Quality of transaction is usually separated into “Fatal” and “Non fatal” errors. Fatal is mandatory. Fatal Errors lead to: Dollar impact to client, Loss of customer to client, Rework at client side. Non-fatal errors lead to client dissatisfaction and delay in work.

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Other Metrics:

TAT (Turn Around Time)

Productivity

Metrics

Sub-Process

Metrics Definition

Cash application

Number of receipts applied divided by Number of receipts (Target) to be applied.

Collections

Number of Collection Calls/mails made by employee divided by target collection calls/mails

Dispute Resolution

Number of disputes worked upon (approved/finalized/resolved/closed) divided by total number of requests received.

Cash application

Number of receipts applied within x days divided by number of receipts received.

Dispute Resolution

Total disputes closed within x days / Total number of disputes closed during measurement period

AR business metrics: Metrics

Metrics definition

Days Sales Outstanding

Twelve (12) month rolling average value of accounts receivable, divided by 12 month rolling sales, multiplied by 360.

Current percentage

A/R balance as at end of measurement period within terms expressed as a percentage of Total A/R balance as at end of measurement period.

Write-off

Total amount written off as Bad Debt to % of Net Sales Booked.

Aging

% of A/R past due greater than target number of days as at end of measurement period.

Unapplied Cash

Total Dollar value unapplied at the end of month

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Key Risk Indicators in AR Process: 1. Customer Master a. Number of duplicate customer masters created b. New customer master created without approval as a % of total customer masters created during a period 2. Sales Orders a. Number of customer complaints about order processing delays/errors b. Number of orders offering special discount without adequate approval 3. Order Release a. Number of accounts exceeding credit limit b. Number of orders put on hold as a % of total number of orders 4. Process Customer Invoice a. Number of billing queries 5. Collection Process a. Number and value of customer accounts referred to Legal Department b. Bad Debts described as percentage of revenue c. Number and value of customer accounts having outstanding for more than 90/120 days d. Number of dishonored checks 6. Customer Receipts a. % of payments mismatched/remain mismatched in the system 7. Customer Returns a. Number of invalid returns b. Number and value of excess value invoice created 8. Credit Limit Review and Assessment a. Number of customer accounts expired for credit limit review

Other Important terms to know

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Terms MICR Number

Miscellaneous Receipt Grace days

Dunning letters

Lock Box

SWIFT

D&B

Explanation MICR stands for Magnetic Ink Character Recognition. The number has two segments. The first segment identifies the bank from which your customer draws the checks. The second segment identifies your customers account at that bank. This is a receipt in respect of revenue that has not been invoiced. Often companies use the concept of grace days whereby they allow their customers some additional days over and above the contracted number of days to make the payment. If customers fail to pay on time, letters called dunning letters are sent to remind them of the payment. Typically, the first dunning letter will be mildly worded while subsequent letters will use increasingly stronger language finally suggesting possible legal action This is the most popular process of handing receipts in the mode of checks. In fact, lock boxes function in the same manner as PO Box. However, lock boxes are maintained and operated by the bank in which the vendor has his account. All customers of such a vendor are advised to send the check payment to the lock box. The bank retrieves all checks by opening the lock box, deposits them into customer account, and provides a copy of the checks to the customer. The copies can be either in form of images of the checks or in the form of paper photocopy. Banks sometimes also send a soft copy of the checks received with details of the customer name, customer code, amount, check number and invoices paid by the customer, and this file helps the customer in auto application of the payments. Whatever payments fail auto application, are then applied manually. The co-operative society, Society for Worldwide Interbank Financial Telecommunications (S.W.I.F.T.) operates a worldwide net to facilitate the transfer of financial messages. By means of these messages banks can exchange data between different financial institutions for transferring funds. Dun & Bradstreet is the leading information provider of businesses about the information for credit, marketing and purchasing decision worldwide. D&B helps to its client for performing a wide range of business analysis. D&B business reports provide a complete view of current and future financial performance for hundreds of companies. These reports contain vital information that helps the organizations to manage credit risk, reduce spending and improving their supply chains. D&B is best known for its D-U-NS (Dun & Bradstreet Universal Numbering System) identifiers which are assigned to over 100 million global companies. Principal customers include manufacturers and wholesalers, insurance companies, Telco’s, banks, and other credit and financial institutions. Revenue in 2005 was $1.443 billion.

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Self-Study Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23.

What is Accounts Receivable and how is it reported in the financial statements? What are the main functions of the AR department? What are the objectives of AR process? What are the different stances that a company can take with regards to credit policy? What are the factors affecting the credit policy of a company? Explain in brief the trade-off between risk and returns. While reviewing the credit of prospective customers, what do companies assess? How do companies assess the ability of customers to pay on time? Explain the terms – credit period and credit limit What are some of the commonly used credit terms? What is the difference between revocable and irrevocable letter of credit? What are the various types of discounts offered to customers? What is a sales order? What are the three types of hold? List the reasons for - why customers might not release payments. What is a customer escalation matrix? What are some of examples of invoice errors? Differentiate between a customer service query and a collection query? How is DSO computed and what does it indicate? What is the rationale behind providing for bad and doubtful debts? What is a claim? Why is it important to apply receipts correctly? What is a factoring agreement? What are different types of factoring agreements possible?

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Glossary 1. Accumulated depreciation: Depreciation charged on depreciable assets from the date of purchase till the reporting date. 2. Customers: A separate legal entity (person, company, or any organization) who purchases goods and services produced by another entity. 3. Depreciation: by charging depreciation the value of an asset is reduced in the account books. This can be due to usage, wear and tear, passage of time, obsolescence, technological outdating or depletion. 4. Depreciable asset: Asset which has a usable life for more than one accounting period, and is held in the business for use in the production or supply of goods and services, for earning rental by subletting to others, or for administrative purposes but not for the resale in the ordinary course of business. 5. Dividends: A distribution to shareholders out of profits earned by the company. 6. Finished Goods: Goods which are ready for sale. 7. Gross Profit: The excess of sales proceeds of goods sold and revenues generated through services rendered during the period over the costs incurred before taking into account the expenses and overheads on administration, selling, distribution, taxes and financing. If the difference is negative, it is referred to as gross loss. 8. Inventory: Inventories are tangible property: held for resale in the ordinary course of business (known as finished goods); or sometimes processed further for production for salable products (known as work in progress); or to be consumed while producing goods or rendering services (known as raw material). 9. Monopoly: A situation in which a single company holds over all or nearly all the market for a given type of product or service. The situations arise due to the case when there is a entry barrier into the industry which allows the single company to operate without competition (for example, barriers to entry, vast economies of scale, or governmental regulation). Monopolies are thus characterized by a lack of economic competition in the market and a lack of viable substitutes available. 10. Obsolescence: reduction in the value of an asset because of its becoming out-of-date or less useful due to technological changes, improvement in production methods, changes in market demand for the product or service output of the asset or legal or other restrictions. 11. Provision for doubtful debts: A provision made for debts considered doubtful of recovery.

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12. Production: the process of transformation of tangible inputs (raw materials or semi-finished goods) and intangible inputs (ideas, information, know how) into more useful goods or services.

13. Raw Materials: Raw Materials are the material which does not undergo any manufacturing or processing operations, but it can be processed further before the final product is ready for sale. For example, a steelmaker uses iron ore and other metals in producing steel. A publishing company uses paper and ink to create books, newspapers, and magazines. 14. Retained Earnings: the sum of a company’s profits, left after dividend payments, since the time of company’s inception. These are basically accumulated net incomes which are retained for reinvestment in the business. They are also called surplus earned, retained capital, or accumulated earnings. 15. Supplier/Vendor: A separate legal entity (person, company, or organization) which sells goods and services to another person, company, or other entity. 16. Work in process: Work in process includes the materials which have undergone a partial manufacturing or processing stage of operations, for this further operation is necessary before to make this product ready for sale.

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