Table of Contents:
Collection of an Account Previously Written off
On occasion, a company may collect an account that was previously written off. For example, a customer that was once in dire financial condition may recover, and unexpectedly pay an amount that was previously written off. The entry to record the recovery involves two steps: (1) a reversal of the entry that was made to write off the account, and (2) recording the cash collection on the account:
It may trouble you to see the allowance account being increased because of the above entries, but the general idea is that another as yet unidentified account may prove uncollectible (consistent with the overall estimates in use). If this does not eventually prove to be true, an adjustment of the overall estimation rates may eventually be indicated.
Carefully consider that the allowance methods all result in the recording of estimated bad debts expense during the same time periods as the related credit sales. These approaches satisfy the desired matching of revenues and expenses.
Monitoring and Managing Accounts Receivable
A business must carefully monitor its accounts receivable. This chapter has devoted much attention to accounting for bad debts; but, don't forget that it is more important to try to avoid bad debts by carefully monitoring credit policies. A business should carefully consider the credit history of a potential credit customer, and be certain that good business practices are not abandoned in the zeal to make sales. It is customary to gather this information by getting a credit application from a customer, checking out credit references, obtaining reports from credit bureaus, and similar measures. Oftentimes, it becomes necessary to secure payment in advance or receive some other substantial guarantee such as a letter of credit from an independent bank. All of these steps are normal business practices, and no apologies are needed for making inquiries into the creditworthiness of potential customers. Many countries have very liberal laws that make it difficult to enforce collection on customers who decide not to pay or use "legal maneuvers" to escape their obligations. As a result, businesses must be very careful in selecting parties that are allowed trade credit in the normal course of business.
Equally important is to monitor the rate of collection. Many businesses have substantial dollars tied up in receivables, and corporate liquidity can be adversely impacted if receivables are not actively managed to insure timely collection. One ratio that is often monitored is the accounts receivable turnover ratio. That number reveals how many times a firm's receivables are converted to cash during the year. It is calculated as net credit sales divided by average net accounts receivable:
Accounts Receivable Turnover Ratio
Net Credit Sales/Average Net Accounts Receivable
To illustrate these calculations, assume Shoztic Corporation had annual net credit sales of $3,000,000, beginning accounts receivable (net of uncollectibles) of $250,000, and ending accounts receivable (net of uncollectibles) of $350,000. Shoztic's average net accounts receivable is $300,000 (($250,000 + $350,000)/2), and the turnover ratio is "10":
10 = $3,000,000/$300,000
A closely related ratio is the "days outstanding" ratio. It reveals how many days sales are carried in the receivables category:
Days Outstanding = 365 Days/Accounts Receivable Turnover Ratio
For Shoztic, the days outstanding calculation is:
36.5 = 365/10
By themselves, these numbers mean little. But, when compared to industry trends and prior years, they will reveal important signals about how well receivables are being managed. In addition, the calculations may provide an "early warning" sign of potential problems in receivables management and rising bad debt risks. Analysts carefully monitor the days outstanding numbers for signs of weakening business conditions. One of the first signs of a business downturn is a delay in the payment cycle. These delays tend to have ripple effects; if a company has trouble collecting its receivables, it won't be long before it may have trouble paying its own obligations.