Accounts Receivable and Bad Debts Expense
When you are running a business or an organization, managing the accounts receivables (A.R.) is a day-to-day affair. You know you have to keep things tight, but you don’t know how to go about it.
What if clients do not pay on time? What if you have a delayed payment? How do you ensure that you have money to spend on marketing and strategizing, and yet have everything functioning just as it should? You don’t want to fire employees, do you?
The one thing that can help you take care of it is ensuring that accounts receivables happen as they should.
So, what is it?
A.R. is the balance that your customers owe your firm for goods or services bought but is yet to be paid. For any sales, an organization needs to send out invoices to the customers for payment. However, there are challenges that organizations have to deal with when it comes to pending amounts.
A firm also extends the line of credit for its customers, with terms that have due payment dates, set with a consensus and can range from weeks to a fiscal or calendar year. And since the customers are legally obliged to pay the debts, organizations consider these receivables as assets.
Current assets involve those amounts receivable that is due in less than a year. In such cases, the firm accepts an IOU (I Owe You) from the customers.
HOW DO BUSINESSES WORK WITH ACCOUNTS RECEIVABLES?
What could be the first thing in your mind when you start a business? Probably expansion? Or getting new clients with the right sales pitch strategy?
And for that, you’ll need customers and sales. To facilitate hassle-free payments and transactions, most of the organizations allow a portion of their sales to go on credit, particularly for customers who are regular.
Some companies allow their customers to pay after the delivery of goods or services. When a customer orders a good, the company waits for the payment and meanwhile, considers these pending invoices as accounts receivable.
WHAT IS THE SIGNIFICANCE OF ACCOUNTS RECEIVABLES?
As many as 93% of businesses receive late payments, and you would need to be prepared for it.
Accounts Receivables are considered to be an essential part of a business. Since most of the receivables are current assets, an organization or a firm deems them as short-term debts.
Analysts assess accounts receivables based on the firm’s frequency of collecting the balance in an accounting period and also analyze the sales outstanding for the receivable balance over a stipulated period. If you do it properly, you keep customer perceptions about your brand in check too.
DIFFERENCE BETWEEN RECEIVABLES AND ACCOUNTS RECEIVABLES
You may have to write off bad debts sooner than you know it. Statistics suggest that on average, companies write off around 4% of their accounts receivable as bad debt, and that can add up quickly if you aren’t careful.
Before we dig in deeper, here is a small difference between two types of receivables in a company. Though both might sound quite similar, you’ll see a difference when you sit to review your financial documents.
Receivables are the financial debts that others owe to your company and as a whole, pretty much cover everything under Trade and Non-Trade Receivables.
- Trade Receivables– Trade Receivables are the credits that your customers owe you for all the goods and services purchased from your company. These receivables are recorded in your company’s balance sheet as current assets.
- Non-Trade Receivables – Non-Trade Receivables come from the transactions, apart from your normal line of business. These have reimbursements from insurance, advance receivables from your employees, receivables from insurance claims and tax returns.
Do all receivables come under A.R.? No. while A.R.is a receivable, not all kinds of receivables are accounts receivables.
ACCOUNTS RECEIVABLES VS. ACCOUNTS PAYABLES
You might have a fair idea on the basics of accounts receivables, so here is a distinction between two types of accounts that your company will fundamentally run on.
While accounts receivables are the amounts pending from a client or customer, accounts payables are debts that your company owes to the suppliers or vendors. You can consider this as an accounting entry in the firm’s book of debts. These are just the opposite of the receivables and reflect as Current Liabilities on the balance sheet.
ACCOUNTS RECEIVABLES AFFECT ON BUSINESS CASH FLOW
For your company to survive in the market, a proper and on-going business cash flow is important. What if your company runs out of cash for any reason? In such a case, there is no way you can withstand the poor financial health for a long time.
In brief, cash flow is the inflow and outflow of money in the business and helps in meeting order requirements, payroll within the company and running other operational activities.
The operational expenses and inflow, especially the receivables and payables, are major factors that calculate the cash flow of your company.
Cash Flow = Operational Cash Flow + Financial Cash Flow + Investment Cash Flow
Accounts receivables hold a significant part in the operating cash flow of your company. Any amount involved in unpaid invoices isn’t considered physical cash flow, because you don’t have the cash in hand.
How do You Ensure You Manage Accounts Receivables Properly?
Did you know that if you have bills overdue for over 90 days, they could be worth as little as 20% of their initial value? You wouldn’t want that, would you? Few tips on how to manage your accounts receivables:
1. Manage Your Accounts Receivables Closely – Unless you track your receivables, you might not have a clear picture of your available cash. The receivables cannot even be considered as a part of your business cash flow because you haven’t received the money yet.
Therefore, it’s important to chase the pending money to make sure that the payments are received positively and to avoid a setback in the actual cash flow you require for your business.
2. Sync Your Receivables With Your Payables – Both accounts receivables and payables are inter-related in a way. While you have money pending from the customers, you also have pending payments that you owe to your suppliers or vendors. These payables include bills, payrolls, operational expenses, and business payments, that you need to pay within a time-frame.
If your customers aren’t diligent about paying on time, your payables will be affected as a result. Also, your receivables might have a window of more than a month, but certain payables cannot wait that long.
Therefore, you need to be careful of the accounts receivable turnover ratio at all times, else you might find yourself in a tough spot in running your business smoothly.
In such cases, it’s a good idea to slightly narrow down the time-frame of receiving payments from your clients and customers.
3. Keeping an Eye on the Outstanding Accounts Receivables – For the growth of a company, it’s a mandate to stay updated as well as upgraded; and both require money. If the inflow is not much compared to your outflow, you will skip either of the two to maintain liquidity in the business.
By keeping an eye on your receivables, and having proper methods of chasing it, you’ll save yourself from going beneath the benchmark.
In case of situations where you aren’t able to wait longer for the receivables but have already provided the customer with a time-frame that hasn’t arrived yet, you can also count on Invoice Factoring. This is a financing tool that allows short-term capital for a business to run, in exchange for the invoices.
You’ll receive 80% of the invoice value right away and rest 20%, once when the payment is complete. However, you get charged a fee for the same, and it’s available only for business to business or business to government invoicing.
4. An Accounts Receivables Process – A docile plan for debt collection might not always work. An assertive approach instead, will help you improve the cash flow. If you can manage the accounts receivable process, you’ll be able to get your money on time systematically. A receivables process will have plans on how you can strategically make sure your receivables aren’t long overdue. Below are few terms you can include to handle such situations effectively.
- Clear out payment terms with your clients/customers and keep it as transparent as possible.
- Always use your brand logo to stand out among multiple invoices that the clients/customers receive every day.
- Everything you write down has to be crystal clear and comprehensible to the clients/customers.
- Being on time and sending out invoices in a particular date or within the dates will let the clients and customers remember you.
- Any late payment needs to be charged. That way the clients/customers will avoid unpunctuality and make payments timely.
- Have a team to call the clients/customers to remind them of their outstanding bills.
5. Revisit Your Policies – If you feel that your business isn’t facing issues as of now and you have enough cash flow to meet requirements, run the operations and even upgrade, you are good with receivables. However, there is always room for improvement. You can always revisit your policies to make the most of them.
To reduce the receivable pressure, you can cut down on your payment timelines. Invest in training your professionals in the accounts receivable team, so that they well versed with the company requirements and processes. Figure out a plan that can help your professionals systematically chase the dues on time.
6. Clear and Short Approval Process – There is no harm in extending your credit, but while doing so, you need to make sure that the process is clear and needs to include instructions on how and when to cancel credit limits and place the defaulter’s account on hold.
Giving in to credits is quite a natural thing when you want to grow your business and improve sales. However, some pitfalls lead to the severe financial health of your company.
7. Bill Electronically – Billing your customers online will help avoid too many hard copies. Paper checks might sound better, but there is more accuracy in electronically generated bills and invoices. Plus, it allows you a hassle-free process.
HIGH ACCOUNTS RECEIVABLE TURNOVER
Now that we have talked about ways of managing your accounts receivables, we also need to emphasize a healthy financial statement of your company.
How do you accomplish that?
If you’re looking to have a healthy financial statement, your company needs to be able to make debt collections efficiently. The accounts receivable turnover of a company explains the collection of average accounts receivables in a year. If the turnover ratio is lower than expected, it shows either low customer quality or an unproductive collection department.
As long as your company can collect credit on time, the business is safe; else it’s high time you looked into the problems seriously.
WHAT IS BAD DEBT EXPENSE?
What happens when your accounts receivables cannot be collected anymore? That’s when you know you have a Bad Debt. Bad debts are a loss that your company endures when the extended credit becomes worthless due to the customers’ inability to pay.
After 90 days overdue, these bad debts are considered uncollectible, and this will further increase the expense in profit and loss statement.
Based on the past experiences, some companies that allow credit sales, estimate the certain percentage of their sales to turn into bad debts; which you can record as provision for credit losses.
THE TOP BAD DEBT SCENARIOS YOU WANT TO AVOID
Imagine you have a company that sells out bicycle parts and you have regular customers who make frequent purchases. Keeping that in mind, you allowed an extended credit to few of the customers on request and had agreed to receive the payment after two months.
However, if these customers are not getting back on time and are also not responding to calls or emails even after two months, they can be considered as low-quality customers.
You might want to keep this under accounts receivable until you feel you can expect money; but if the customers haven’t shown positive signs of paying the pending amount, you can consider them as bad debts and also write it off after 90 days.
There are two methods for recording the amount of Bad Debts Expense:
1. Direct Write-Off Method – In this method, the uncollected account is identified and then removed from accounts receivables. This method results in debt to the bad debt expense and a credit to the receivables for the amount written-off and you need it while filing your U.S. income taxes.
2. Allowance Method – In this method, a company foresees the accounts receivables that will not be collected. It is said that this method is more helpful comparatively, since the balance sheet will have a more realistic amount to be collected from the accounts receivables, and also, these bad debts expense will be reported closer to the time of credit sales on the firm’s statement.
When both balances are registered in the balance sheet, the loan receivable account will be reduced. Firms use statistical calculations to estimate the bad debts expense and determine the probable losses, based on the historical data. Also, a bad debts expense can be assessed using the percentage of the net sales based on previous experiences.
HOW BAD DEBT EXPENSE AFFECTS YOUR BUSINESS?
Whether you want to extend the time of payment for the customer or want to write it off directly depends on your decision, but before that, you need to be mindful of the payment terms and conditions. Once your payment terms are set, communicate to the customers and then follow up diligently. Failing to adhere to these terms will affect both the customers as well as the business.
Why write-off an outstanding invoice?
Writing off an outstanding invoice will give you a precise scenario of the financial health of your company. This will avoid unnecessary overstatement of your revenue, assets, and earnings from those assets by the end of the year.
How can you ensure better bookkeeping? For better bookkeeping, you need an accounting method for your company to follow. It’s easy to get confused as to which accounting method to own. Nevertheless, it is one of the vital decisions you need to make as you’ll be sticking to it for a long time.
ACCRUAL VS. CASH ACCOUNTING
There are two options you have for accounting method: Cash basis accounting and Accrual accounting. In the former, the sales and purchase are recorded as soon as you receive money from the customer or pay a bill.
In accrual accounting, a sale is recorded the moment you provide goods or services, and an expense is counted when you purchase the same from the vendor, irrespective of the payment being received/paid or not.
1. Cash Basis Accounting – Small businesses generally go for this, where the purchase and sales are recorded as and when cash is received or paid.
For example, if you are supplying notebooks to an office, you will not record the sale until you receive payment for the sale made. Once you have received the payment, you can include this in the book.
Similarly, the papers and covers you purchase for the notebook manufacturing cannot be recorded in the book as a purchase, unless you make payments for the same. Once the payment is made, you can include this under purchase.
2. Accrual Accounting – This method allows you to record the sales and purchases as and when the delivery is done, or services are fulfilled.
For example, if you are supplying 100 notebooks to an office, you will make an invoice to bill the customer. You can record it in the book immediately, irrespective of you receiving the payment or not.
Similarly, when you purchase the raw materials, you need to record the purchase immediately after receiving them from the vendor, even if the payment isn’t yet done.
Accrual accounting can be a little challenging for you, considering the cash ambiguity within the anticipated period, especially when a customer owes you money. You may or may not receive the payment due from the customers, and might end up facing a bad debt. However, if it becomes difficult to track, you can even consult bookkeeping professionals available, either online or personally.
IMPACT OF THE BAD DEBT EXPENSE ON YOUR FINANCIAL STATEMENTS
Like we mentioned before, writing off an outstanding invoice as bad debt is ideal because it will help avoid overstating your revenue and reflects actual collectible amount from the clients and customers. But in any case, bad debt is always a loss for your business and is best avoided with practical methodologies.
Here is how bad debts affect a company’s balance sheet and profit and loss statements.
How Bad Debt Affects the Financial Statements:
|Account Affected||Impact on Account||Financial Statement|
|Bad Debt Expense||Increase||Profit and Loss|
|Accounts Receivable||Decrease||Balance Sheet|
HOW TO KNOW YOUR CUSTOMERS?
When you are new in a business, it might not always seem possible to be able to judge your customers. To increase sales and clients, you might as well go ahead of your credit limit, and time of payment you set for them.
However, there are few basic attributes that you can easily pick to understand if it’s time to write-off invoices of those customers or waits for a while.
- You’ve waited long enough, but the customer is not contacting you regarding the dues. The only reason behind such response is an intention on not paying.
- You are trying to make contacts, but the customer won’t answer your calls. When customers start ignoring your calls, it indicates that they are not ready to make payments.
- Even after extended credit, if a customer is not communicating with you, it’s time you understood they are likely to be bad debts.
If you have gone through this already, you may want to revisit your collection process and make changes. You might find loopholes somewhere in the current process if it’s not working well for your business.
To add value to your process, you can also include discounts to early customers, encouraging timely payments and late charges on the defaulters to avoid delay on the same. One way of chasing your money is by following up rigorously. You can either set a team to do the needful or send out reminders religiously.
TAKING BAD DEBTS OFF YOUR BUSINESS TAX RETURN
Loans to customers and sales on credit are a part of the business. If an investment doesn’t do well, you cannot consider that a bad debt altogether. The IRS allows you a deduction in case of business bad debt that has become partially or fully valueless.
However, you’ll be required to run your business on accrual accounting method for deductions on bad debts. Below are few steps on writing off bad debts by the year-end.
- Sum up your Bad Debts – Make a list of all the defaulters by the end of the year and check if you have attempted collection from them or not.
- Accounts Receivable Aging Report – This report will include all the money you are yet to receive from the customers and how long it has been outstanding.
- Add Bad Debts on Business Tax Return – You can deduct all your bad debts if you can file your taxes (business) on Schedule C.
(However, when it comes to cash basis accounting, you cannot register bad debts expense deduction until you are paid for your goods or services. You may have a receivable, but you must collect the receivable to record the income. No income recorded, no bad debt.)
If you have already reported unpaid invoices on a previous year’s return as income, you may claim the bad debts as a business expense on Line 8590 of Form T2125. Each year, the IRS allows a deduction for bad debts you suffered.
Since bad debts are uncollectible, you’ll never receive your money. Therefore, the government helps you by deducting that amount on your taxes. However, there are terms and conditions before you can claim for the deduction.
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