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Accounts Receivable--AR is a legally enforceable claim for payment held by a business against its customer/clients for goods supplied and/or services rendered in execution of the customer's order. These are generally in the form of invoices raised by a business and delivered to the customer for payment within an agreed time frame. AR is the money that a company has a right to receive because it had provided customers with goods and/or services. For example, a manufacturer will have an AR when it delivers a truckload of goods to a customer on June 1 and the customer is allowed to pay in 30 days. From June 1 until the company receives the money, the company will have an AR (and the customer will have an account payable). ARs are also known as trade receivables. Companies who sell on credit are unlikely to have liens on their customers' property. Hence, there is a risk that the full amount of their AR might not be collected. This means that companies need to cautious when granting credit and establishing an AR. If there is uncertainty of a potential (or existing) customer's credit worthiness, it is wise for the company to require the customer to pay with a credit card before delivering goods or services. It is also important for a company to monitor its AR and to immediately follow up with any customer who has not paid as agreed. An aging of AR is a tool that will help and it is readily available with most accounting software. A general rule is that the older a receivable gets, the less likely it will be collected in full. AR is reported as a current asset on a company's balance sheet. Good accounting requires that an estimate be made for the amount that is unlikely to be collected. That estimate is reported as a credit balance in a related receivable account such as Allowance for Doubtful Accounts. Any adjustments to the Allowance balance will also be recorded in the income statement account Uncollectible Accounts Expense.
AR is shown in a balance sheet as an asset. It is one of a series of accounting transactions dealing with the billing of a customer for goods and services that the customer has ordered. These may be distinguished from notes receivable, which are debts created through formal legal instruments called promissory notes. AR represents money owed by entities to the firm on the sale of products or services on credit. In most business entities, AR is typically executed by generating an invoice and either mailing or electronically delivering it to the customer, who, in turn, must pay it within an established timeframe, called credit terms or payment terms. The AR department uses the sales ledger, because a sales ledger normally records: The sales a business has made; The amount of money received for goods or services; The amount of money owed at the end of each month varies (debtors). The AR team is in charge of receiving funds on behalf of a company and applying it towards their current pending balances. Collections and cashiering teams are part of the AR department. While the collections department seeks the debtor, the cashiering team applies the monies received.
It's a simple turn of events that creates an AR. In order to have an AR, you need two things: a sale and a purchase. A company sells an item or a service to a buyer and extends credit to that buyer so that the total cost of the sale can be paid later and on terms that are agreed upon by the seller and the buyer. When the buyer agrees to the terms set forth by the seller, then a purchase has been made. Now, if that extension of credit is not given, and payment is rendered at the time of sale, then no AR was created. Once the AR is created, it has to be recorded in the accounting records. Since the AR account is considered an asset account, it is recorded in the ledger and reported on the balance sheet of a company. Whoa - that's a lot of terms there, isn't it? Let us explain them just a little better. An asset is something that a company owns. The ledger is the place where all the increases and decreases in balance sheet accounts are recorded. The balance sheet is the financial statement that reports all the accounts of a company and their balances. Now that clarifies things, doesn't it? Let's talk about the actual recording process. Every single transaction that occurs in a company has at least one account that is credited and one account that is debited. To record a sale that resulted in an AR, you would need to make a debit entry to the AR account for the sale amount and a credit entry to the revenue account for the same amount. Revenue is the amount of money that is received or will be received from a sale. By debiting the AR account and crediting the revenue account, the balances in both accounts increase. When payment is received on the account, the cash account is debited for the payment amount, and the AR account is credited. This decreases the amount in the AR account and increases the cash account balance. Each time a payment is made on a customer account, it will decrease the AR balance, just as each time a new credit sale is made, it will increase the balance in the AR account.
On a company's balance sheet, AR is the money owed to that company by entities outside of the company. AR’s are classified as current assets assuming that they are due within one calendar year or fiscal year. To record a journal entry for a sale on account, one must debit a receivable and credit a revenue account. When the customer pays off their accounts, one debits cash and credits the receivable in the journal entry. The ending balance on the trial balance sheet for AR is usually a debit. Business organizations which have become too large to perform such tasks by hand (or small ones that could but prefer not to do them by hand) will generally use accounting software on a computer to perform this task. Companies have two methods available to them for measuring the net value of AR, which is generally computed by subtracting the balance of an allowance account from the AR account. The first method is the allowance method, which establishes a contra-asset account, allowance for doubtful accounts, or bad debt provision, that has the effect of reducing the balance for AR. The amount of the bad debt provision can be computed in two ways, either (1) by reviewing each individual debt and deciding whether it is doubtful (a specific provision); or (2) by providing for a fixed percentage (e.g. 2%) of total debtors (a general provision). The change in the bad debt provision from year to year is posted to the bad debt expense account in the income statement. The second method is the direct write-off method. It is simpler than the allowance method in that it allows for one simple entry to reduce AR to its net realizable value. The entry would consist of debiting a bad debt expense account and crediting the respective AR in the sales ledger. The two methods are not mutually exclusive, and some businesses will have a provision for doubtful debts, writing off specific debts that they know to be bad (for example, if the debtor has gone into liquidation.)
The AR process is the process by which businesses receive payments from customers for goods or services sold. The process has several steps: 1) Credit Decisions: the supplier of goods and services checks if the prospective customer is of sufficient credit worthiness to warrant the supply of the products or services under an account arrangement. 2) Billing and Bill Distribution: happens once the good/services have been supplied. Payments: are completed by the customer once they are ready to pay. 3) Receipting, Allocations and Reconciliation: This step is undertaken by an AR Officer. The AR Officer identifies a payment deposited into the supplier bank account, receipts it into the AR system, allocates it to an invoice and reconciles to ensure that the payment is correct. 4) Collections: The Collections Officer identifies all invoices that are short paid or unpaid as of the due date. 5) Disputes Management: if the customer disputes a bill/invoice typically, this step is typically managed between a Collections Officer and the customer. 6) Bad Debt: once the bill/invoice reaches a set date and/or is under dispute and is not resolvable to the satisfaction of the supplier, it would then be considered a “bad debt”.
AR services help to: Reduce Days Sales Outstanding (DSO), Reduce cash collection shortfalls, Reduce A/R adjustments and bad debt write-offs, Gain visibility into receivables transactions, Focus on your core business activities (rather than being stuck in back-office processes), Ensure more effective credit control, Maintain healthier accounts by lowering the revenue costs, Rectify unallocated cash values, Reduce the operational costs as well as overheads, Access flexible workforce for quick and easy decision making in order to meet business requirements, Access more consistent customer interaction and communication which ultimately enhances your customer base, Maximize collections by offering extensive Credit control, Improve the overall productivity. Giving AR services to an expert company help to: Focus on core business activities rather than back-office processes; Better visibility of outstanding cash values, to ensure more effective credit control; Lower revenue costs leading to healthier looking accounts; No more unallocated cash values that you have no access to; Reduction in operational costs and overheads; Access to a flexible workforce who can shift focus quickly and easily, in order to meet evolving business needs; More consistent communication with your customer base; Maximized collections – Credit control is carried out on ‘real’ outstanding debt; Improved productivity.
Companies can use their AR as collateral when obtaining a loan (asset-based lending). They may also sell them through factoring or on an exchange. Pools or portfolios of AR can be sold in capital markets through securitization. For tax reporting purposes, a general provision for bad debts is not an allowable deduction from profit - a business can only get relief for specific debtors that have gone bad. However, for financial reporting purposes, companies may choose to have a general provision against bad debts consistent with their past experience of customer payments, in order to avoid over-stating debtors in the balance sheet. Associated accounting issues include recognizing AR, valuing AR, and disposing of AR. Other types of accounting transactions include accounts payable, payroll, and trial balance.
AR constitutes the primary source of incoming cash flow for most businesses, so you should analyze these invoices in aggregate to ascertain the health of the underlying cash flows. One of the easiest methods for analyzing the state of a company's AR is to print an AR aging report, which is a standard report in any accounting software package. This report divides the age of the AR into various buckets, which you can sometimes alter within the accounting software to match your billing terms. The most common time buckets are from 0-30 days old, 31-60 days old, 61-90 days old, and older than 90 days. Any invoices falling into the time buckets representing periods greater than 30 days are cause for an increasing sense of alarm, especially if they drop into the oldest time bucket. There are several issues to be aware of when you analyze based on an aging report, which are: 1) Individual credit terms. Management may have authorized unusually long credit terms to specific customers, or perhaps only for particular invoices. If so, these items may appear to be severely overdue for payment when they are, in fact, not yet due for payment at all. 2) Distance from billing date. In many companies, the majority of all invoices are billed at the end of the month. If you run the aging report a few days later, it will likely still show outstanding AR from one month ago for which payment is about to arrive, as well as the full amount of all the receivables that were just billed. In total, it appears that receivables are in a bad state. However, if you were to run the report just prior to the month-end billing activities, there would be far fewer AR in the report, and there may appear to be very little cash coming from uncollected receivables. 3) Time bucket size. You should approximately match the duration of the time buckets in the report to the company's credit terms. For example, if credit terms are just ten days and the first time bucket spans 30 days, nearly all invoices will appear to be current. 4) Unapplied credits. There may be unapplied credits on the report. If so, clean up the report by researching which invoices they should have been applied against. Doing so may reduce the amount of overdue receivables listed on the report. 5) Another AR analysis tool is the trend line. You can plot the outstanding AR balance at the end of each month for the past year, and use it to predict the amount of receivables that should be outstanding in the near future. This is a particularly valuable tool when sales are seasonal, since you can apply seasonal variability to estimates of future sales levels.
Trend line analysis is also useful for comparing the percentage of bad debts to sales over a period of time. If there is a strong recurring trend in this percentage, management may want to take action. For example, if the percentage of bad debt is increasing, management may want to authorize tighter credit terms to customers. Conversely, if the bad debt percentage is extremely low, management may elect to loosen credit in order to expand sales to somewhat more risky customers. This is a particularly useful tool when you run the bad debt percentage analysis for individual customers, since it can spotlight problems that may indicate the imminent bankruptcy of a customer. There are several issues to be aware of when you use trend line analysis, which are: 1) Change in credit policy. If management has authorized a change in the credit policy, this can lead to sudden changes in AR or bad debt levels. 2) Change in products or business lines. If a company adds to or deletes from its mix of products or business lines, this may cause profound changes in the trend of AR. 3) Change in business conditions. If the economy is in decline, there may be an increasing trend of bad debts that is well above the historical average. 4) A third type of AR analysis is ratio analysis. The most commonly used ratio is the AR collection period, which reveals the number of days that an average customer invoice remains outstanding before it is paid. The formula is: Average AR/Annual sales/365 Days. For example, if there are usually $500,000 of AR outstanding at any time, and annual sales are $3.65 million, then the AR collection period is calculated as: $500,000 AR / ($3,650,000 Annual sales / 365 Days) = 50 Days collection period. In the example, we cannot tell if a 50-day collection period is good or bad, since we do not know the duration of the credit terms.
The best way to analyze AR is to use all three techniques noted here. You can use the AR collection period to get a general idea of the ability of a company to collect its AR, add an analysis of the aging report to determine exactly which invoices are causing collection problems, and then add trend analysis to see if these problems have been changing over time. An interesting analysis related to AR is a trend line of the proportion of customer sales that are paid at the time of sale, noting the payment type used. Changes in a company's selling procedures and policies may shift sales toward or away from up-front payments, which therefore has an impact on the amount and characteristics of AR.
If your company is subject to an annual audit, the auditors will review its AR in some detail. AR is frequently the largest asset that a company has, so auditors tend to spend a considerable amount of time gaining assurance that the amount of the stated asset is reasonable. Here are some of the AR audit procedures that they may follow: 1) Trace receivable report to general ledger. The auditors will ask for a period-end AR aging report, from which they trace the grand total to the amount in the AR account in the general ledger. (If these totals do not match, you may have a journal entry somewhere in the general ledger account that should not be there). 2) Calculate the receivable report total. The auditors will add up the invoices on the AR aging report to verify that the total they traced to the general ledger is correct. 3) Investigate reconciling items. If you have journal entries in the AR account in the general ledger, the auditors will likely want to review the justification for the larger amounts. This means that these journal entries should be fully documented. 4) Test invoices listed in receivable report. The auditors will select some invoices from the AR aging report and compare them to supporting documentation to see if they were billed in the correct amounts, to the correct customers, and on the correct dates. 5) Match invoices to shipping log. The auditors will match invoice dates to the shipment dates for those items in the shipping log, to see if sales are being recorded in the correct accounting period. This can include an examination of invoices issued after the period being audited, to see if they should have been included in a prior period. 6) Confirm AR. A major auditor activity is to contact your customers directly and ask them to confirm the amounts of unpaid AR as of the end of the reporting period they are auditing. This is primarily for larger account balances, but may include a few random customers having smaller outstanding invoices. 7) Review cash receipts. If the auditors are unable to confirm AR, their backup auditing technique is to verify that customers have paid the invoices, for which they will want to review checks copies and trace them through your bank account. 8) Assess the allowance for doubtful accounts. The auditors will review the process that you follow to derive an allowance for doubtful accounts. This will include a consistency comparison with the method you used in the last year, and a determination of whether the method is appropriate for your business environment. 9) Assess bad debt write-offs. The auditors will compare the proportion of bad debt expense to sales for this year in comparison to prior years, to see if the current expense appears reasonable. 10) Review credit memos. The auditors will review a selection of the credit memos issued during the audit period to see if they were properly authorized, whether they were issued in the correct period, and whether the circumstances of their issuance may indicate other problems. They may also review credit memos issued after the period being audited, to see if they relate to transactions from within the audit period. 11) Assess bill and hold sales. If you have situations where you are billing customers for sales despite still retaining the goods on-site (known as "bill and hold"), the auditors will examine your supporting documentation to determine whether a sale has actually taken place. 12) Review receiving log. The auditors will review the receiving log to see if it records an inordinately large amount of customer returns after the audit period, which would suggest that the company may have shipped more goods near the end of the audit period than customers had authorized. 13) Related party receivables. If there are any related party receivables, the auditors may review them for collectibility, as well as whether they should instead be recorded as wages or dividends, and whether they were properly authorized. 14) Trend analysis. The auditors may review a trend line of sales and AR, or a comparison of the two over time, to see if there are any unusual trends. Another possible comparison is of receivables to current assets. They may also measure the average collection period. If so, expect them to make inquiries about the reasons for changes in the trends.
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