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Accounts Receivable Management

(ARM)

Tariq Mumtaz
What is Account Receivable?

Accounts receivable (A/R) is one of a series of accounting transactions dealing


with the billing of customers who owe money to a person, company or
organization for goods and services that have been provided to the customer. In
most business entities, this is typically done by generating an invoice and mailing
or electronically delivering it to the customer, who in turn must pay it within an
established timeframe called credit or payment terms.

While booking a receivable is accomplished by a simple accounting transaction,


the process of maintaining and collecting payments on the accounts receivable
subsidiary account balances can be a full time proposition. Depending on the
industry in practice, accounts receivable payments can be received up to 10 - 15
days after the due date has been reached. These types of payment practices are
sometimes developed by industry standards, corporate policy, or because of the
financial condition of the client.

An example of a common payment term is Net 30*, meaning payment is due in


the amount of the invoice 30 days from the date of invoice. Other common
payment terms include Net 45 and Net 60 but could in reality be for any time
period agreed upon by the vendor and client.

Standard Account Receivable Process

* Net 30
Net 30 is a form of trade credit,
which specifies payment is expected
to be received in full 30 days after
the goods are delivered. Net 30
terms are often coupled with a credit
for early payment; e.g. the notation
"2% 10, net 30" indicates that a 2%
discount is provided if payment is
received within 10 days of the
delivery of goods, and that full
payment is expected within 30 days.
For example, if "$1000 2/10 net 30"
is written on a bill, the buyer can
take a 2% discount ($1000 x .02 =
$20) and make a payment of $980
within 10 days.
On a company's balance sheet, accounts receivable is the amount that customers
owe to that company. Sometimes called trade receivables, they are classified as
current assets. On a company's balance sheet, accounts receivable is the amount
that customers owe to that company. Sometimes called trade receivables, they are
classified as current assets. 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 accounts receivable is always debit.

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 accounts receivable is always debit.

Since not all customer debts will be collected, businesses typically record an
allowance for bad debts, which is subtracted from total accounts receivable. When
accounts receivable are not paid, some companies turn them over to third party
collection agencies or collection attorneys who will attempt to recover the debt via
negotiating payment plans, settlement offers or legal action. Outstanding advances
are part of accounts receivables if a company gets an order from its customers
with payment terms agreed in advance.

Companies can use their accounts receivable as collateral when obtaining a loan
(asset-based lending) or sell them through factoring (finance). Pools or portfolios
of accounts receivable can be sold in the capital markets through a securitization.

The Outstanding bills; for any organization are receivable items or debts to collect
* Trial Balance from organization. The Simple AR Process diagram shows the ideal situation.
In accounting, the trial balance is a
worksheet listing the balance at a
However the process shown may not follow in real life.
certain date, of each ledger account
in two columns, namely debit and Certain there are certain defined business processes which are followed to collect
credit. Under the double-entry
system, in any transaction the total
the outstanding invoices. The process of collection of outstanding Bills can be
of any debits must equal the total of categorized into two.
any credits, so in a Trial Balance the
total of the debit side should always
be equal to the total of the credit
side. The trial balance thus serves as
First Party Collection
a tool to detect errors, which can
result in the totals not being equal. When the original creditor’s “in house” collection department does the collection.
Often credits will be represented as a
negative, in which case the total of
Some agencies are departments or subsidiaries of the company that owns the
the trial balance should be 0. original debt. First party agencies typically get involved earlier in the debt
collection process and have a greater incentive to try to maintain a constructive
* Current Assets customer relationship because they are a part of the original creditor, first party
In accounting, a current asset is an agencies are not subject to some of the laws which govern collection agencies.
asset on the balance sheet, which is
expected to be sold or otherwise
used up in the near future, usually These agencies are called "first party" because they are part of the first party to the
within one year, or one business
cycle - whichever is longer. Typical
contract (i.e. the creditor). The second party is the consumer (or debtor).
current assets include cash, cash
equivalents, accounts receivable, Typically, most creditors will retain accounts with first party agencies for a period
inventory, the portion of prepaid
accounts which will be used within a
of around 6 months before the debt is written off and passed to a Third Party
year, and short-term investments. On Agency. They are NOT subject to the FDCPA as are 3rd party collection
the balance sheet, assets will agencies.
typically be classified into current
assets and long-term assets.
First Party AR Collection Process Diagram

Third Party Collection

The term collection agency is usually applied to third-party agencies, called such
because they were not a party to the original contract. The creditor assigns
accounts directly to such an agency on a contingency-fee basis, which usually
initially costs nothing to the creditor or merchant, except for the cost of
communications. This however is dependent on the individual service level
agreement (SLA) that exists between the creditor and the collection agency. The
agency will then take a percentage of the debt that is successfully collected;
sometimes known in the industry as the "Pot Fee" or potential fee upon
successful collection. The collection agency makes money only if money is
collected from the debtor (often known as a "No Collection - No Fee" basis).
Depending on the type of debt the fee ranges from 10% to 50% (though more
typically the fee is 15% to 35%).

Some agencies offer a flat fee, typically $10.00, and pre-collection “or” soft
collection service. The service sends a series of increasingly urgent letters, usually
ten days apart; instructing debtors to pay the amount owed directly to the creditor
or risk a collection action and negative credit report. Depending on the terms of
the SLA, these accounts may revert to "hard collection" status at the agency's
regular rates if the debtor does not respond.
In the United States, consumer third-party agencies are subject to the Fair Debt
Collection Practices Act of 1977 (FDCPA). This federal law is administered by
the Federal Trade Commission or FTC. This act limits the hours during which the
agency may call the debtor. It also prohibits false, deceptive or misleading
representations, and prohibits the agency from making threats of actions the
agency cannot lawfully or does not intend to take.

Third Party Collection Process Diagram

Regulation of Collection Agencies


The modern business model is the primary reason for the many complaints
brought against collection agencies. Debt collectors who work on commission
may be highly motivated to convince debtors to pay the debt, often to the point
that they sound threatening to the debtors. Most people are accustomed to being
treated with a certain amount of customer service and often complain that they do
not receive that treatment from debt collectors.

The Federal Trade Commission is the primary federal regulator of collection


agencies. Many states and a few cities require collection agencies be licensed
and/or bonded. In addition, many states have laws regulating debt collection, to
which agencies must adhere (see Fair debt collection).

The Fair Debt Collection Practices Act is the primary United State Federal law
governing debt collection practices. The FDCPA* allows aggrieved consumers to
file private lawsuits against a collection agency that violates the Act. Alternately,
the Federal Trade Commission or the state attorney general may take action
Internet Resource for FDCPA against a noncompliant collection agency, including issuing fines, ordering
http://www.ftc.gov/bcp/edu/pubs/consumer/cre damages, restricting its operations or even closing it down.
dit/cre27.pdf
The FDCPA specifies that if a state law is more restrictive than the federal law,
the state law will supersede the federal portion of the act. Thus, the more
restrictive state laws will apply to any agency that is located in that state or makes
calls to debtors inside such a state.

In addition to state and federal laws, a majority of U.S. collection agencies belongs
to trade group ACA International and agrees to abide by the association's code of
ethics as a condition of membership. ACA's standards of conduct require its
members to treat consumers with dignity and respect, and to appoint an officer
with sufficient authority to handle consumer complaints. Consumers may also
resolve disputes brought against a collection agency who is a member of ACA
through ACA's consumer complaint resolution program.

Terms & Jargons in FDCPA

Collection Calls
Collection calls inform a debtor of his obligation and motivate repayment. In the
US, the FDCPA prohibits calls to the debtor if the call will cost the debtor toll
charges or air time charges. If a person answers, the call center may track statistics
(e.g., the times and days when someone answers) in order to place calls at times
when the debtor is more likely to be home.

Successful collection calls also rely on the skill and understanding of the collector
making the call. Quite often a collector only has the first initial phone call to
establish a rapport with the debtor and to help work out a solution to the debt
owed. This may take the form of a payment plan or a discount on the principal
amount that is owed.

In international debt, collection cases the collection calls are often made in a
foreign language. This is useful if the debtor's knowledge of English is limited and
it is quite often this lack of English that is used as a debtor excuse for non-
payment.

1. Collection agencies may contact individuals other than the debtor, with
important limitations.
2. Under the FDCPA, a collector is permitted to call a neighbor or relative
for help in locating the person who owes a debt, as long as there is no
communication about the debt.
3. Collectors must state their name and must give the name of their
employer if the person specifically asks.
4. A collector may contact each person once, unless it is believed that the
person gave the collector incorrect or incomplete information at the time,
but now has complete or updated information.
* Example for Point 6 5. Collectors may contact a debtor at the workplace unless the collector has
Vic tims of iden tity th eft, peop le
erroneous ly targ eted due to a been informed the employer prohibits such calls.
sim ila r na me, o r peop le who
othe rw ise dis pute the valid i ty o f the 6. At times, a collector in error may contact a person with no connection to
d e b t . I n t h e U n i t e d S ta te s u n d e r t h e the debt or the debtor. *
F D C P A , a n y o n e h a s th e r i g h t fo r
any reason to re quest, in w r iting ,
validation o f the deb t or to de ma nd
th e c o lle c to r c e a s e c o m mu n ic a tio n .
Collection Account
Collection account is the term used to describe a person's loan or debt, which has
been submitted to a collection agency through a creditor. The term is not used on
debts with only original creditors.

The collection account normally appears on the credit report of a person (debtor)
who has had one or more accounts referred to collection agencies, within the last
seven years. Collection fees can range from $500 to $50 000. [2] The name of the
collection agency, and the amount of money a person owes, will be listed in the
report. Also, in some cases, the agency's contact information is listed. If a debtor
pays off a collection account, the item will not be removed from the credit reports
- it will simply be marked "Paid."

Debtors
The person who owes the bill or debt is called the debtor. People may become
debtors because of a lack of financial planning or over commitment on their part,
or due to an unforeseen and uncontrollable event that disrupted their life.

Examples include the loss of a well paying job, an accident that leaves them
unable to work, or a sudden and serious illness. Americans for Fairness in
Lending and other non-profits can help debtors know what their rights are.

In commercial collection cases, the debtor is a business. This includes sole


proprietors, corporations, partnerships or individuals that incurred the debt for
business purposes.

Accounts Receivable Financing or Factoring


Factoring is a financial transaction whereby a business sells its accounts receivable
(i.e., invoices) at a discount. Factoring differs from a bank loan in three main
ways.

1. First, the emphasis is on the value of the receivables, not the firm’s credit
worthiness.
2. Secondly, factoring is not a loan – it is the purchase of an asset (the
receivable).
3. Finally, a bank loan involves two parties whereas factoring involves three.
Factoring Process
The three parties directly involved are: the seller, debtor, and the factor.
The second party, the debtor, owes the seller money (usually for work
performed or goods sold).
The seller then sells one or more of its invoices at a discount to the third
party, the specialized financial organization (aka the factor or 3rd Party
Collection Agency) to obtain cash.
The debtor then directly pays the factor or 3rd Party collection Agency
the full value of the invoice.
Involved Parties
Invoice sellers
The invoice seller presents recently generated invoices to the factor in exchange
for a dollar amount that is less than the value of the invoice(s) by an agreed upon
discount and a reserve.

A reserve is a provision to cover short payments, payment of less than the full
amount of the invoice by the debtor, or a payment received later than expected.
The result is an initial payment followed by a second one equal to the amount of
the reserve if the invoice is paid in full and on time or a credit to the account of
the seller with the factor.

In an ongoing relationship, the invoice seller will get their funds one or two days
after the factor receives the invoices.

Astute invoice sellers can use a combination of techniques to cover the range of
1% to 5% plus cost of factoring for invoices paid within 50 to 60 days or more. In
many industries, customers expect to pay a few percentage points higher to get
flexible sales terms.

In effect the customer is willing to pay the supplier to be their bank and reduce
the equity the customer needs to run their business. To counter this it is a
widespread practice to offer a prompt payment discount on the invoice. This is
commonly set out on an invoice as an offer of a 2% discount for payment in ten
days.

Invoice sellers can also seek a cash discount from a supplier of 2 % up to 10%
(depending on the industry standard) in return for prompt payment. Large firms
also use the technique of factoring at the end of reporting periods to ‘dress’ their
balance sheet by showing cash instead of accounts receivable There are a number
of varieties of factoring arrangements offered to invoice sellers depending upon
their specific requirements. The basic ones are described under the heading
Factors below.

Factors (3rd Party Collection Agency)


When initially contacted by a prospective invoice seller, the factor first establishes
whether or not a basic condition exists, does the potential debtor(s) have a history
of paying their bills on time? That is, are they creditworthy? The factor is willing
to consider purchasing invoices from all the invoice seller’s creditworthy debtors.

The classic arrangement which suits most small firms, particularly new ones, is full
service factoring where the debtor is notified to pay the factor {notification} who
also takes responsibility for collection of payments from the debtor and the risk of
the debtor not paying in the event the debtor becomes insolvent, non recourse
factoring. This traditional method of factoring puts the risk of non-payment fully
on the factor. If the debtor cannot pay the invoice due to insolvency, it is the
factor's problem to deal with and the factor cannot seek payment from the seller.
The factor will only purchase solid credit worthy invoices and often turns away
average credit quality customers. The cost is typically higher with this factoring
process because the factor assumes a greater risk and provides credit checking and
payment collection services as part of the overall package.
Invoice Payers (debtors)
Large firms and organizations such as governments usually have specialized
processes to deal with one aspect of factoring, redirection of payment to the
factor following receipt of notification from the third party (i.e., the factor) to
whom they will make the payment. Many but not all in such organizations are
knowledgeable about the use of factoring by small firms and clearly distinguish
between its use by small rapidly growing firms and turnarounds.

Distinguishing between assignment of the responsibility to perform the work and


the assignment of funds to the factor is central to the customer/debtor’s
processes. Firms have purchased from a supplier for a reason and thus insist on
that firm fulfilling the work commitment. Once the work has been performed
however, it is a matter of indifference who is paid.

For example, General Electric has clear processes to be followed, which


distinguish between their work and payment sensitivities.

Reason for Factoring


A company sells its invoices, even at a discount to their face value, when it
calculates that it will be better off using the proceeds to bolster its own growth
than it would be by effectively functioning as its "customer's bank."

In other words, it figures that the return on the proceeds will exceed the income
on the receivables.

Benefits

Pass off Collections: Outsourcing your accounts receivable management


to another company, frees up your resources to focus on other more
productive activities such as selling.

Free up Working Capital: Many companies have the majority of capital


tied up in inventory. Accounts receivable funding allows a company to
free up capital tied up in inventory.

Quick Financing: Accounts receivable factoring will not require a


business plan or tax statements. It's a quick form of cash often used for
businesses experiencing a cash crunch.

Factoring Year Book Site


http://www.factorscan.com/folder_detail.aspx?
id=BE553073-54F7-4B02-9D4D-
252C597892B1
Skiptrace
Skiptracing (also skip tracing) is a colloquial term used to describe the process of
locating a person's whereabouts for any number of purposes. The term comes
from the word "skip" being used to describe the person being searched for, and
comes from the idiomatic expression "to skip town," meaning to depart, perhaps
in a rush, and leaving minimal clues behind for someone to "trace" the "skip" to a
new location.

A skiptracer is someone who performs this task, which may be the person's
primary occupation.

Skip tracing tactics may be employed by debt collectors, bail bond enforcers
(bounty hunting), private investigators, attorneys, police detectives, journalists or
as a part of any investigation that entails locating a subject whose contact
information is not immediately known.

Method

Skiptracing is done by collecting as much information as possible about the


subject, which is then analyzed, reduced, and verified. Sometimes the subject's
current whereabouts are in the data, but is obfuscated by the sheer amount of
information or disinformation. More often, the data will be used to identify third
parties that might be able to assist the process.

This is where the job becomes more than mere research since one must often
employ methods of social engineering to finesse information without
compromising the situation. A common tactic involves calling or visiting former
neighbors, employers or other known contacts to ask about the subject,
sometimes under false or misleading pretenses. In most jurisdictions this
deception, known as pretexting, is legal.

Records that "skiptracers" use may include

Phone number databases,


Credit Reports
Job application information,
Criminal background checks,
Utility bills,
Social security,
Public tax information.

These methods don't break any law because the information is freely available due
to the nature of the business, whether it be debt collectors, bounty hunters, or
other "skiptracers".

Even when no specific information is returned, public databases exist that cross-
reference skiptracing information with others the "skip" may have lived with
within the recent past. For instance, if previous records show a "skip" lived in the
same house as a third party, the third party may also be "skip traced" in an effort
to locate the "skip".
Account Receivable Analysis
Analyzing the accounts receivables using the methodology outlined below is the
simplest avenue in finding out what is happening to your money. The analysis tells
how much your accounts receivables increase or decrease. You can see why you
are not collecting enough money.

Percentage Change in Account Receivable


If the receivables increased, chances are that there is a problem with follow-up
and collections.

In a hospital many times, a weak front desk causes the problem with collections.
Critical information like patients eligibility, changes of insurance company, lack of
referrals and pertinent patients’ demographic data is not recorded correctly.
Consequently, bills to insurance companies are rejected and denied.

Another common problem that causes an A/R incremental is that the billing staff
has problem coding and pricing services. Denials are not scrutinized and rejected
claims are not corrected and re-submitted to carriers.

The formula to determine the percentage of the changes in receivable is:

((PAYMENTS + ADJUSTMENTS)/CHARGES) * 100%

{(P+A)/C} 100

EXAMPLE:
On December 31, 1999 the Accounts Receivable of the XYZ Practice was
$295,000

FIRST MONTH OPERATION

Charges during January 2000: $ 75,000


Payments received in January 2000: $35,000
Adjustments made in January 2000: $15,000
((35,000 + 15,000) / 75,000) * 100% = 66.67%

A/R increased by 33.33% (100% – 66.67)


Note
The simplest technique to verify if Net changes: A/R increased during the month of January 2000 by $25,000
your staff is performing follow-ups
is by checking your telephone bill
for the last twelve months. If you Total A/R increased to $320,000 (25,000 + 295,000)
do not have enough long distance
calls to insurance carriers, this is
indicative that a problem exists.
Measuring Average Collection Period

The average collection period measures the length of time it takes to convert your
average sales into cash. This measurement defines the relationship between
accounts receivable and your cash flow.

A longer average collection period requires a higher investment in accounts


receivable. A higher investment in accounts receivable means less cash is available
to cover cash outflows, such as paying bills.

The average collection period is calculated by dividing your present accounts


receivable balance by your average daily sales.

The average daily sales volume is computed by dividing your annual sales amount
by 360:

EXAMPLE:
David owns and operates an auto supply and repair shop. David's total annual
sales amount from the previous year was $200,000.

The total balance of his accounts receivable at the end of the same year was
$20,000. David's average collection period is calculated as follows:

David's average daily sales volume is $556 per day.

Average collection period is

200,000 / 556=360 i.e. 36 days


Accounts Receivable to Sales Ratio

The accounts receivable to sales ratio looks at your investment in accounts


receivable in relation to your monthly sales amount. The accounts receivable to
sales ratio helps you identify recent increases in accounts receivable.

Using monthly sales information, the accounts receivable to sales ratio can serve
as a quick and easy way to look at recent changes in accounts receivable. The
more recent information of the accounts receivable to sales ratio will quickly point
out cash flow problems related to your business's accounts receivable.

The accounts receivable to sales ratio is calculated by dividing your accounts


receivable balance at the end of any given month by your total sales for the
month.

EXAMPLE:
Dick's accounts receivable balance at the end of the previous month was $15,000,
and the total sales amount from that same month was $10,000.

Dick's accounts receivable to sales ratio of 1.5 is calculated as:

15,000/10,000=1.5

Accounts Receivable Turnover Ratio

Accounts Receivables Turnover is a close cousin to the Inventory Turnover ratio.


It can be used to determine whether the company is having trouble collecting on
sales it provided customers on credit.

To compute Accounts receivable turnover, divide sales made on credit by average


accounts receivable.

Note
An increase in your accounts
receivable to sales ratio from one
month to the next indicates that Average Sales on Credit and Average Account Receivable can also be used to find
your investment in accounts out the AR Turnover Ratio. When this is done, it is important to remain
receivable is growing more rapidly
than sales. This is often one of consistent.
the first signs of a cash flow
problem.
Days Sales Outstanding (DSO)

Days Sales Outstanding is a company's average collection period. A low number


of days indicate that the company collects its outstanding receivables quickly.
DSO is considered an important tool in measuring liquidity. DSO tends to
increase as a company becomes less risk averse.

Higher DSO can also be an indication of poor follow up on


delinquencies.
Higher DSO might be the result of inadequate analysis of applicants for
open account credit terms.
An increase in DSO can result in cash flow problems, and may result in a decision
to increase the creditor company's bad debt reserve.

Days Sales Outstanding, or DSO, is calculated as: Total Outstanding Receivables


at the end of the period analyzed divided by Total Credit Sales and resultant
multiplied by days for the period (typically 30, 90 or 365 days)

Typically, DSO is calculated monthly. The Days Sales Outstanding (DSO) figure
is an index of the relationship between outstanding receivables and sales achieved
over a given period.

The DSO analysis provides general information about the number of days on
average that customers take to pay invoices.

EXAMPLE:
Total Accounts Receivables (from Balance Sheet) = $97,456
Total Credit Sales (from Income Statement) = $727,116
Number of days in the period = 1 year = 360 days (some take this number as 365
days)

DSO = [$97,456 / $727,116] x 360 = 48.25 days

The Interpretation:
Lumber & Building Supply Company takes approximately 48 days to convert its
accounts receivables into cash. Compare this to their Terms of Net 30 days. This
means at an average their customers take 18 days beyond terms to pay.

Subject Matter Document © [October 2008]


Tariq Mumtaz